A systemic risk to the financial system might be lurking in mutual funds’ portfolios, which could be subjected to the same mass withdrawals seen in bank runs. New research shows a regulation aimed at shielding mutual funds from such runs seems to instead make the funds more fragile.
Research from John Heater and Elia Ferracuti of Duke University’s Fuqua School of Business found that the 2018 “Liquidity Rule” introduced by the Securities and Exchange Commission (SEC) is distorting the way the majority of mutual funds fulfill withdrawal requests from their clients. The funds, known as open-end funds, pool assets and allow continual new contributions and withdrawals. The professors say the change in how withdrawals are managed is exposing them to further risk of runs.
Heater, Ferracuti and co-authors explain their findings in a working paper presented at an SEC’s Annual Conference on Financial Market Regulation and to the European Unions’ Financial Stability Board.
“Open-end funds are critically important to the economy,” Heater said. “They manage more than $20 trillion of assets for over 70 million households in the U.S. It is just phenomenally important to ensure that people who invest in those funds have the ability to get their money out when they demand it.”
The Withdrawal Process
The SEC’s Liquidity Rule followed the bankruptcy of Third Avenue in 2018. The rule mandates funds to keep a certain percentage of liquid assets (and also puts a cap on the highly illiquid assets).
Regulators had raised concerns about the stability of open-end funds since the early 2010s, the researchers said, and were especially worried about bond funds (mutual funds investing primarily in bonds). “It's harder to sell certain types of bonds, for example, high-yield and distressed debt bonds,” Heater said. “They are very difficult to liquidate in a manner that won't impact the price.”
The SEC requires withdrawal requests from mutual funds—called redemptions—to be satisfied within seven days. The funds, in order to give money back to the shareholders, need to sell some of their assets if they do not have available cash on hand. The more illiquid the assets, the researchers said, the higher the potential loss if they need to sell them within the required seven days.
Normally, the researchers said, you would expect the funds would sell their liquid assets first. “Liquid” by definition means the assets have an active, deep and robust market, Heater said. This was the intention of SEC’s Liquidity Rule, which aimed at providing a liquidity buffer to satisfy spikes in redemption requests.
The Unintended Consequence
The researchers found that after the SEC rule, the funds seem to be more prone to sell their illiquid assets, rather than tapping the liquid reserves.
By quickly selling their illiquid assets, the funds expose themselves to further risk of runs. “They shrink their asset base very quickly and make the investors nervous,” Ferracuti said.
The researchers compared U.S. and Canadian funds. They noticed that before the SEC rule, the two countries were similar in terms of liquid assets holdings. During the 2008-2009 financial crisis, both countries used their liquid assets to satisfy the withdrawal requests—as expected.
But after the 2018 rule change, two differences emerged: 1) The U.S. funds increased their liquidity buffers as mandated by the rule; 2) But during the COVID crisis, particularly for funds facing the highest amount of redemption requests, the Canadian funds kept using their liquid assets to satisfy the requests, while the U.S. funds tapped their illiquid holdings to maintain required levels of liquidity.
“The regulatory authority thought that under stress they needed to allow the funds to have some liquidity buffer,” Heater said. “But because they are required to maintain liquidity, we see that it's sitting there almost like gold in Fort Knox.”
This creates market fragility, the researchers said, the very thing the regulation intended to reduce.
“Our paper documents an unintended consequence: portfolio managers, on average, opt to sell illiquid holdings to satisfy these redemption requests instead of using liquidity buffers as designed,” Heater said.
A Larger Economic Problem
The SEC’s Liquidity Rule is rigid, the researchers explained. It mandates a static percentage of liquid assets be held by the fund, with the specific threshold to be decided by the board. But fund managers are reluctant to tap that liquidity, a buffer which they would then need to replete.
“Fund managers are extremely sensitive to career concerns. For them to go to the board and say, ‘we need more liquidity’ would require a big effort. The only thing they want to show to boards is that they're beating their benchmark.” Heater said.
The “fire-sale” of the more lucrative assets, and the fragility it creates for mutual funds, has serious consequences for corporate access to credit, the researchers said.
Mutual funds own about 30% of the corporate bond market, they said, second only to insurers. The rapid sale of these bonds lowers their market price and consequently increases their yield (the interest the issuer pays), which is higher when the bond price goes down.
“If you're a business owner, and mutual funds are now selling the bonds they normally buy from your risky business, you're going to care a lot,” Heater said. “Your costs are going to go up, and you may not be able to secure capital.”
The researchers found that after the SEC rule, corporate bonds experienced an increase in yield.
“Our conservative, back-of-the-envelope calculation suggests that the rule resulted in a $2.4 billion premium for illiquid bond issuers,” Heater said.
A Potential Solution
The researchers believe a way to fix this unintended fragility would be to mandate “dynamic liquidity buffers,” whereby in good economic times the percentage of liquid holdings goes up and in bad times it goes down. They say this is a system similar to the “countercyclical capital buffers” suggested for commercial banks, after the global financial crisis.
“If you don’t force funds to become countercyclical, and you don’t create a rule that mandates dynamic liquidity, then the buffers will go unused when needed,” Heater said.
The systemic risk posed by this issue is potentially bigger than what we’ve seen with commercial banks, Heater said.
“We don't have the benefit of the FDIC [Federal Deposit Insurance Corporation],” Heater said. “If the SEC must unwind multiple bond funds that are insolvent, they don't have the resources to do it effectively. There's no government backstop that guarantees deposits.”