We propose a unified framework to study liquidity provision by debt-issuing versus equity-issuing financial intermediaries. We show that both types of 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 inefficient premature liquidation of longterm investments. Informed by the theory, we develop the Liquidity Provision Index (LPI) as a unified measure of liquidity provision. We find that, at the end of 2017, the per dollar liquidity provision by bond mutual fund shares amounts to a quarter of that by uninsured bank deposits. The majority of the gap arises from the difference in contract forms instead of regulatory features such as deposit insurance. Further applying the LPI to money market funds (MMFs), we identify a 20% drop in liquidity provision due to the change from debt to equity funding around the 2016 MMF Reform.
Ma, Yiming, Kairong Xiao, and Yao Zheng. "Debt versus Equity in Liquidity Provision." Columbia Business School, January 1, 2020.
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