For banks, the great compression may get worse before it gets better.  After years of unremitting complaints that persistently low interest rates are squeezing profits out of the banking system, hopes are high that a change in U.S. monetary policy later this year could finally provide some relief.  Now a change under way in the money-market fund industry has cast a shadow of doubt over this.  Fidelity Investments announced plans last week to convert Fidelity Cash Reserves, the largest U.S. prime money-market fund, to a government-only fund. Two other funds are also changing their status. This means that they will shed their private-sector assets in favor of Treasurys and debt issued or backed by Fannie Mae, Freddie Mac and Ginnie Mae.  This is a response to new rules governing money-market funds that are designed to avoid runs on deposits and thereby reduce systemic risk. The rules require prime funds aimed at institutional investors to abandon the practice of disclosing a stable net asset value and instead post a floating number based on the market value of their investments. They also subject all nongovernment funds to the potential of redemption “gates”—periods in which depositors cannot withdraw funds—and liquidity fees.  The push toward government debt could add some downward pressure on Treasury yields. But for banks the more serious issue could be the need to replace their short-term unsecured funding with more expensive sources.  The three funds that have already announced the change hold roughly $100 billion of unsecured bank paper, estimates Barclays analyst Joseph Abate. If other prime funds take the same path, demand for bank paper could contract.  This is no small matter. Banks are far and away the largest nongovernment issuers of short-term debt to money-market funds. Many of the large issuers are foreign banks that need U.S. dollar funding. But the largest U.S. banks also issue a lot to the funds. At the close of 2014, money-market funds held $35.4 billion of paper issued by J.P. Morgan Chase JPM -0.21 % and $35.1 issued by Wells Fargo, WFC -0.70 % according to Crane Data. Citigroup C -0.33 % had issued $21.9 billion held by money-market funds.  Replacing funding lost to money-market fund conversions isn’t likely to be ruinous—merely expensive. Still, that could mean that the long contraction of net interest margins at banks won’t suddenly end with a rate increase from the Federal Reserve.  Write to John Carney at john.carney@wsj.com
New rules for money market funds are shrinking the market for short term bank debt. That could undermine the long-anticipated improvement in banks’ net interest margins.