The financial system has fragmented from the days when banks were the dominant force in financial markets. This is the shadow financial system which is not controlled by the Fed. Money funds clearly have an important role in short-term lending. Now we see state money funds, who have been the aggregators of smaller pools of cash being affected by the SIV crisis. With smaller investors pulling funds from larger pools like in the state of Florida, there are bank runs. The only way to solve the problem is to close the window to withdrawals.
Assume that there is some small percentage of a large pool holding sub-prime SIV commercial paper. You are a small investor in the fund and decide to pull your money. The percentage that SIV commercial paper represents in the fund will then increase which may lead to greater withdrawals. Who want to be the small investors left in the larger pool that is getting riskier? Florida may not be alone in the bank run scenario. If fact, this could be a problem in a number of states and could spill over to retail money funds. This would be a blow to investor confidence which will have a strong impact on the rest of the markets. The herd can move fast once it hears shots.
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