Debt versus Equity in Liquidity Provision

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.