Major financial crises all follow the same scenario.
There is an initial unexpected shock which weakens part of the financial system. The shock can have many different origins (real estate crisis, bursting of a financial bubble, rise in interest rates, etc.). Given enough time, balance sheets could be repaired, perhaps with help from governments, but panic sets in and creditors fail to renew credit lines to weakened institutions. When institutions bear too much liquidity risk (i.e. financing long-term assets with short-term liabilities), this panic can lead to a systemic collapse of the financial sector.
Therefore, to ensure financial stability we must act on two fronts:
- The prevention. Ensure that financial institutions have strong balance sheets in terms of solvency AND liquidity to be able to cope with unexpected shocks.
- The reparation. Ensure that weakened financial institutions can access new capital. As we explain here, the badly thought new resolution powers granted to regulators do just the opposite and, as we saw during the mini-banking crisis of spring 2023, make it very difficult to attract new capital.
A significant part of our work in the past has been devoted to the key question of liquidity: how to build a “run-free” financial system in which investors can access their wealth without triggering a systemic crisis when they panic (see this paper for a full discussion of this complex question). We particularly stressed that the redemption rules for open-end mutual funds should be adapted to make the system more resilient.
Thus, we fully support the SEC’s recent efforts to radically improve how in the US mutual funds manage “dilution,” “first-mover advantage,” and the risk of “runs” (see the SEC proposed rule). However, we believe that the SEC’s economic analysis is a bit superficial when it comes to the welfare-enhancing properties of mutual funds and that swing pricing does not appear to be an optimal solution. In this short memo, sent as a comment to the SEC, we briefly discuss alternatives.