Bank Debt versus Mutual Fund Equity in Liquidity Provision

70 Pages Posted: 5 Dec 2019 Last revised: 19 Feb 2021

See all articles by Yiming Ma

Yiming Ma

Columbia University - Columbia Business School

Kairong Xiao

Columbia University - Columbia Business School

Yao Zeng

University of Pennsylvania - The Wharton School

Date Written: May 29, 2020

Abstract

We propose a unified framework to compare and quantify liquidity provision by debt-issuing banks and equity-issuing mutual funds. We show that both types of financial intermediaries provide liquidity by insuring against idiosyncratic liquidity risks. However, they are subject to distinct constraints depending on the contractual form of their liabilities. Banks issue demandable debt, which exposes them to the possibility of panic runs, whereas funds issue demandable equity, which leads to fundamentals-driven outflows. Based on our theoretical framework, we develop the first empirical measure of liquidity provision that can be generally applied across demandable-debt- and demandable-equity-issuing financial institutions: the Liquidity Provision Index (LPI). We find that a dollar invested in bond mutual funds provides 4.8 cents of liquidity, which is economically significant at one-quarter of the liquidity provided by uninsured bank deposits at the end of 2017. The gap between bank and fund liquidity provision has continuously narrowed over time, suggesting a migration of liquidity provision away from the deposit-taking banking sector to equity-funded non-banks. We find Quantitative Easing and post-crisis liquidity regulation to be contributing factors for this trend. Finally, we exploit the 2016 Money Market Reform, in which institutional prime Money Market Funds (MMF) switched from a fixed to a floating share value, to corroborate the effect of contractual forms on liquidity provision.

Keywords: Liquidity provision, mutual fund, bank

JEL Classification: G21, G23

Suggested Citation

Ma, Yiming and Xiao, Kairong and Zeng, Yao, Bank Debt versus Mutual Fund Equity in Liquidity Provision (May 29, 2020). Jacobs Levy Equity Management Center for Quantitative Financial Research Paper, Available at SSRN: https://ssrn.com/abstract=3489673 or http://dx.doi.org/10.2139/ssrn.3489673

Yiming Ma

Columbia University - Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

Kairong Xiao

Columbia University - Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

Yao Zeng (Contact Author)

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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