“Bank Debt versus Mutual Fund Equity in Liquidity Provision” by Dr. Yao Zeng
Dr. Yao Zeng
Assistant Professor of Finance
University of Pennsylvania
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 as in Diamond and Dybvig (1983) but with distinct frictions. The fixed value of debt induces panic runs whereas the flexible payoff of equity leads to fundamentals-driven outflows. Both frictions constrain liquidity provision by generating premature liquidation of long-term investments. Informed by the theory, we develop the Liquidity Provision Index (LPI) as the first empirical measure of liquidity provision that can be generally applied across demandable debt and demandable equity issuing financial institutions. We find that a dollar invested in bond fund shares provides a significant amount of liquidity amounting to one quarter of that by uninsured bank deposits at the end of 2017. We confirm that the majority of the gap arises from the difference in contract forms instead of regulatory features such as deposit insurance by applying the LPI to the Money Market Reform, in which institutional prime Money Market Funds (MMF) switched from a fixed to a floating share value. Over time, the gap between bank and fund liquidity provision has continuously narrowed, 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.