Bank Balance Sheet Constraints and Mutual Fund Fragility

Abstract

Using European data, we develop a methodology to connect individual bonds and dealer banks, utilizing two intuitive and striking patterns: the home bias and the persistence of underwriting relationships. Building on these connections, we show that the introduction of the leverage ratio for European banks had a large impact on bond liquidity. We also show that the bond mutual funds’ outflows following the 2020 pandemic outbreak affected substantially more mutual funds with larger exposures to dealer banks’ balance sheet constraints. These findings highlight the importance of interactions between the regulation of banks and financial fragility of non-banks.

Keywords: Bond liquidity; market-making; capital requirements; leverage ratio; mutual funds; COVID-19

JEL Classification: G12, G18, G21