Federal Reserve Bank of New York President William C. Dudley pauses as he talks with a small business owner at the Brooklyn Chamber of Commerce in New York
Federal Reserve Bank of New York President William C. Dudley pauses as he talks with a small business owner at the Brooklyn Chamber of Commerce in New York June 10, 2011. Reuters

The Federal Reserve Bank of New York is proposing that money market managers be empowered to hold back depositors' money for 30 days in the event of a run on funds. The controversial proposal is being called by critics a kind of capital control.

The proposed capital control measure, which is being endorsed by Robert Dudley, president of the New York Fed, calls for money market funds, which hold a total of about $2.7 trillion, to set aside a portion of every investor's recent balance at a minimum balance at risk (MBR). Money from this reserve, the New York Fed said, can be withdrawn only after a one-month notice, a deferral that ensures investors remain partially invested in the fund long enough to absorb any costs or losses that may arise from their fund withdrawals.

The proposal intends to make money market funds less vulnerable to runs that arise when panic-stricken investors redeem their money from the funds at times of distress. It also seeks to protect small and less-savvy investors, who do not pull out of troubled money funds immediately.

By discouraging investors from redeeming from a troubled money market fund, the MBR would help the fund avoid the need for fire sales of assets to raise cash. This not only benefits the fund and its investors, but it reduces the contagion risk that one fund's strains can propagate throughout the financial system, the bank said.

The New York Fed's proposal come two weeks after three of the world's biggest financial institutions in the U.S. -- JPMorgan Chase (NYSE: JPM), Goldman Sachs (NYSE: GS) and BlackRock Inc. (NYSE: BLK) -- blocked new investments in their European money market funds after the European Central axed its benchmark rate to a record low of 0.75 percent and slashed deposit rates to zero, a move that the banks feared would take a toll on global investor confidence.

A money market fund is a form of mutual fund that makes investments in low-risk securities. Money market funds have historically been the most reliable investments since they hold a combination of highly liquid assets and less-liquid, longer-dated securities. They operate on a stable share value - a feature that has attracted a large and diverse base of sophisticated investors, who are inclined to bolt from money funds at the slightest sign of trouble.

The Chamber of Commerce and the money market industry are unhappy with the proposal. Tom Quaadman, a vice president at the Chamber of Commerce's Center for Capital Markets Competitiveness, criticized efforts to empower money managers to hold back client money.

These are the wrong reforms at the wrong time, he told Reuters.

Financial blog Zerohedge denounced efforts such as the New York Fed's proposal as an implicit attempt at capital controls by the government on one of the primary forms of cash aggregation available.