The Consequences of Fund-level Liquidity Requirements
37 Pages Posted: 20 May 2022
Date Written: April 28, 2022
We investigate the effects that mutual fund liquidity requirements have on fragility. In 2018, SEC Rule 22e-4 restricted ownership of illiquid securities in funds. As expected, post-rule, funds hold more liquid securities. Firms issuing illiquid securities face higher costs due to a smaller investor pool. However, higher liquidity does not ameliorate adverse shocks. Facing outflows, funds maintain cash levels and sell illiquid securities. This is because liquidity requirements are not sufficiently countercyclical: funds must maintain cash even when they should use it to mitigate flow pressures. Hence, outflows force funds to sell more illiquid securities post-rule change, unintentionally increasing fragility.
Keywords: Liquidity Requirements, Fragility, Corporate Bond Funds
JEL Classification: G23, G28
Suggested Citation: Suggested Citation