We propose a unied framework to compare and quantify liquidity provision by traditional debt-issuing commercial banks and equity-issuing non-banks. We first 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 renders investor redemptions more sensitive to news on fundamentals, i.e., a flow-to-fundamentals relationship. 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. At the end of 2017, bond mutual fund shares provide a significant amount of liquidity amounting to one-quarter of that by uninsured bank deposits. We confirm that the majority of the gap arises from the difference in contract forms instead of regulatory features such as deposit insurance. We further use the switch by institutional prime Money Market Funds (MMF) from a fixed to a floating value during the MMF Reform to corroborate the capacity of demandable equity in liquidity provision. Over time, the gap between bank and fund liquidity provision has continuously narrowed. Quantitative Easing and post-crisis liquidity regulation have contributed to the migration of liquidity provision away from the traditional deposit-taking banking sector to equity-funded non banks.
Ma, Yiming, Kairong Xiao, and Yao Zheng. "Bank Debt versus Mutual Fund Equity in Liquidity Provision." Columbia Business School, August 21, 2020.
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