Board of Governors of the Federal Reserve System

April 16, 2021

Bank Borrowings by Asset Managers Evidence from US Open-End Mutual Funds and Exchange-Traded Funds

Fang Cai and Chaehee Shin¹

Introduction

Open-end mutual funds and exchange-traded funds ("ETFs") engage in liquidity transformation by offering daily redemptions to investors, notwithstanding the liquidity profile of funds' underlying assets. Such liquidity transformation, combined with a first-mover advantage, could lead to investor runs and asset fire sales (Coval and Stafford 2007, Chen, Goldstein, and Jiang 2010, Goldstein, Jiang, and Ng 2017). The heavy investor redemptions experienced by many of these funds in March 2020 was a manifestation of their structural vulnerabilities.

While it is well-known that mutual funds and ETFs use various tools for liquidity risk management, including cash reserves, short-term liquid investments, and derivatives, little is known about the scope of the funds' access to and reliance on credit lines from banks. Although liquidity management in normal times mostly favor the convenience of using cash reserves and liquid derivatives such as futures, cash and derivatives give lower returns compared with returns from relatively illiquid investments and can thereby reduce investment efficiency. As such, many mutual funds open and maintain credit lines with banks to prepare for times of turmoil when it becomes extremely strenuous to rely solely on cash reserves or derivatives.

In this note, we look into investment funds' access to and usage of bank credit, based on a new dataset on credit line (and other types of loan) extension by top bank holding companies to open-end mutual funds and ETFs in the United States. We find that the aggregate amount of bank lending to open-end funds and ETFs was small and greatly fluctuated across time. Bank credit, particularly in the form of credit lines, has offered funds a flexible liquidity source from which they can draw down cash in times of excessive fund outflows, such as during the onset of the COVID-19 pandemic outbreak. In particular, funds that hold relatively more illiquid assets, such as bank loan funds, are more reliant on bank credit lines.

Data and Methodology

We create a new dataset on credit extension by banks to mutual funds and ETFs based on data made available from Federal Reserve Comprehensive Capital Analysis and Review stress tests. Specifically, we use the supervisory FR Y-14 data that show quarterly amounts of various types of corporate loans and their usage reported by U.S. bank holding companies ("BHCs"), intermediate holding companies of foreign banks, and covered savings and loan holding companies with $100 billion or more assets.²

For the purpose of this analysis, we first identify open-end mutual funds and ETFs from the obligors that appear on FR Y-14 based on a methodology that combines two strategies.³ The first strategy uses string-matching of obligor names with mutual fund family and individual fund names that are available from the CRSP mutual fund database. The second strategy involves using comprehensive lists of (non-) mutual fund/ETF keywords to identify an obligor as a mutual fund/ETF (or drop from such possibility). For instance, we capture obligors whose names contain "BALANCED FUND," "LARGE CAP," "RUSSELL 1000," etc.⁴

We augment the FR Y-14 data with additional information on mutual funds and ETFs, such as their net flows and fund asset classes from Morningstar and CRSP mutual fund databases, and additional credit line information obtained from the SEC's new N-CEN reporting, which began in December 2018.⁵

In the end, our final sample contains around 200 unique U.S. mutual fund families that had at least one loan or credit line facility with the FR Y-14-reporting banks over the period of 2013:Q1-2020:Q3.

Types of Credit Facilities Used by Mutual Funds and ETFs

In general, there are several types of credit facilities that banks offer to firms. Among them, the primary types are term loans and lines of credit. Term loans are most often used for specific, one-off expenses, while lines of credit, which can be revolving or non-revolving, are used to cover ongoing or emergency expenses. Table 1 shows that, while only 14 percent of facilities took the form of term loans, nearly 67 percent of credit facilities provided to open-end mutual funds and ETFs were revolving or non-revolving lines of credit during our sample period.⁶ These lines of credit are the precautionary liquidity sources which the funds can tap in times of heavy outflows.

Table 1. Types of Credit Facilities Used by Mutual Funds and ETFs, 2013:Q1-2020:Q3

The precautionary characteristic of funds' borrowings from banks is also shown in the diversification of banks they borrow from. For instance, according to the N-CEN filings in 2019, one of the credit lines owned by T. Rowe Price had a combined $800 million committed from 13 different BHCs including Bank of America, Citibank, Goldman Sachs, JPMorgan, and Wells Fargo. John Hancock Funds had multiple lines of credit of $275 million from Citibank, $137.5 million each from Bank of Nova Scotia and Royal Bank of Canada, and $100 million each from State Street and Wells Fargo. BNY Mellon had two lines of credit of $830 million and $200 million from Citibank, and yet another line of $300 million from its own, Bank of New York Mellon.

In addition, because outflows are hard to predict, multiple funds under the same fund family most often share the bank lines of credit. In the above examples, T. Rowe Price Floating Rate Fund, Inc. and T. Rowe Price Floating Rate Multi-Sector Account Portfolio shared the $800 million credit line. John Hancock Funds' multiple lines of credit were shared by 183 John Hancock funds. BNY Mellon's lines of credit from Citibank were shared by 107 funds under BNY Mellon.

Who Borrows from Banks?

Certain fund types have a higher need for bank lines of credit due to their predominantly illiquid holdings and thus a potential for unusually rapid investor redemptions. For a subset of FR Y-14 obligors for whom we successfully identified Lipper class types via string-matching, Table 2 lists the Lipper class types of mutual funds and ETFs that had the largest number of total credit lines (revolving and non-revolving) from banks. Illiquid fund types such as bank loan funds (or so-called Loan Participation funds by Lipper), high yield bond funds, real estate funds, municipal bond funds, and emerging markets funds are the largest fund classes that borrowed from banks. This observation is consistent with and extends the results from Chernenko and Sunderam (2016) that find funds with illiquid assets and flow volatility to hold larger amounts of pure cash holdings. We find that these same (illiquid) funds not only have higher levels of cash but also maintain larger amounts of loans and credit lines from banks in case that their need for liquidity exceeds their cash holdings.

Table 2. Top 20 Lipper Classes of Mutual Funds and ETFs by Total Number of Credit Lines from Banks, 2013:Q1-2020:Q3

Bank Lending to Open-End Mutual Funds and ETFs

Figure 1(a) shows the total amount of bank lending—in the forms of term loans and committed credit lines combined—of U.S. mutual funds and ETFs from large banks, from 2013:Q1 to 2020:Q3. Over the period, the amount of large bank credit that these funds altogether had access to fluctuated in the range of $28-40 billion. The reduction in the number of unique borrowers and the average amount of loan both contributed to driving down the aggregate amount of credit extension to open-end funds and ETFs since 2015.⁷ As a share of the funds' total net assets, the total credit extension corresponded to 0.1-0.3% of the funds' total assets, implying that the dependence of the aggregate mutual fund industry as a whole on bank credit has stayed fairly low.⁸

By contrast, the economic magnitude of funds' reliance on bank credit is likely to be higher for the fund types with extremely illiquid holdings, such as those from Table 3. To learn about the differential importance of bank credit for these funds, we focus on bank loan open-end mutual funds and bank loan ETFs. Unlike the approach taken for the whole mutual fund industry, we identify these funds at the individual fund-level using a more sophisticated matching. Our final sample identifies and follows at least 40 unique bank loan funds. Figure 1(b) shows that these funds maintained, in aggregate, a bank credit amounting to $1.4-3.2 billion, or 1.2-3.4% of their total net assets during the sample period. In other words, bank credit maintained by bank loan funds was larger than that maintained by the whole industry, by a factor of around 10.⁹ As Anadu and Cai (2019) finds that bank loan funds held around 5% of total net assets in cash and cash-equivalent holdings in recent years, the economic magnitude of bank credit commitment is substantial from the bank loan fund's point of view. The magnitude implies that bank loan funds had an additional liquidity buffer of an average of 2% of their total assets on top of their liquidity holdings of around 5% of total assets.

Figure 1. Large Bank Lending to U.S. Open-end Mutual Funds and ETFs, 2013:Q1-2020:Q3

1a. All Open-end Mutual Funds and ETFs

1b. Bank Loan Mutual Funds and ETFs

Investor Flows and Credit Line Drawdowns

While the previous subsection looked at the overall credit extension by banks to open-end funds and ETFs, this subsection examines the actual drawdowns of the extended credit, in particular, in relationship to fund net flows. Once a credit line is drawn, the number of days that the line of credit are in use most often varies from one day to a few weeks, implying that the drawdown is mostly likely used to bridge the time gap between investor redemptions and the sales and settlement of underlying assets. Therefore, we would expect to see a negative correlation of (lagged) fund net flows and its credit line usage. ¹⁰

Figures 2(a) and (b) show how the drawdown of credit lines, as a share of total committed credit lines, fluctuates with net flows, for all mutual funds/ETFs and bank loan mutual funds/ETFs, respectively. Consistent with our expectation, we observe an overall negative relationship between them, for the whole fund industry and also for bank loan funds. Bank loan funds' highly flow-dependent reliance on bank credit is consistent with Anadu and Cai (2019)'s observation that bank loan funds increase the drawdown on credit lines in periods of stress with large outflows. It is relatively more challenging to interpret the time trend, that is, the decline in bank loan funds' drawdown of individual credit lines, because this sample of credit lines only comprises of individual lines extended to each bank loan fund and does not include lines of credit that a bank loan fund shares with other funds in the same fund family. Therefore, the true magnitude of bank credit drawdown by bank loan funds may be higher than the conservative estimate here.

Figure 2. Investors Flows and Credit Line Drawdowns, 2013:Q1-2020:Q3

2a. All Open-end Mutual Funds and ETFs

2b. Bank Loan Mutual Funds and ETFs

Bank Borrowings and Credit Line Drawdowns by Open-End Funds and ETFs during the COVID-19 Outbreak

In the wake of the COVID-19 outbreak, many funds—especially those that held corporate debt and bank loans—experienced heavy investor redemptions. Table 3 shows the development in total credit extension by large banks to open-end funds and ETFs and the drawdowns before and after the pandemic outbreak. As of the end of March, mutual funds and ETFs increased their drawdown on revolving credit lines amid heavy quarterly outflows, despite a decline in banks' total credit commitment to these funds. In particular, the drawdown by bank loan funds drawdown increased by around 40%, from $190 million to $270 million, which corresponded to an increase in the percent of used credit lines from 11% to 17%. While still modest, these jumps in the credit line usage by bank loan funds were larger in magnitude than those shown in the whole sample of mutual funds and ETFs, suggesting that the drawdown in 2020:Q1 was indeed related to the liquidity management.

Although banks seem to have reduced their overall exposure to mutual funds and ETFs since the outbreak of COVID-19, the total available bank credit to bank loan funds actually increased to more than 6% of the funds' total assets as of 2020Q1, due to the shrinking size of bank loan fund assets. Since around 83% of the credit lines remains unused, this untapped liquidity amounts to at least 5% of bank loan funds' total net assets, which can be of use on top of their 5% cash and cash equivalent on average (according to Anadu and Cai (2019)). This additional buffer would help with the funds' short-term liquidity needs along with SEC's temporary borrowing relief on mutual funds that allow them to temporarily deviate from fundamental investment policies in terms of borrowing and lending and ease restrictions on interfund lending and borrowing from affiliates.

Table 3. Borrowings from Large Banks by U.S. Open-end Mutual Funds and ETFs around the COVID-19 Outbreak

Conclusion

In this note, we look into the supervisory FR Y-14 data to examine banks' credit extension to open-end mutual funds and ETFs in the United States, and especially around the onset of COVID-19. We find that, while it is common for mutual funds and ETFs to have credit lines with banks, the overall dependence of the aggregate mutual fund industry on bank credit has remained fairly low. However, funds investing in relatively illiquid assets, such as bank loan funds, are more reliant on bank revolving credit lines that serve as a flexible source of liquidity in times of stress. Drawdown of credit lines negatively move with net fund flows, as evident in the March 2020 episode.

References

Anadu, K. and Cai, F., 2019. "Liquidity Transformation Risks in U.S. Bank Loan and High-Yield Mutual Funds", FEDS Notes No. 2019-08-09.

Chen, Q., Goldstein, I. and Jiang, W. 2010. "Payoff complementarities and financial fragility: Evidence from mutual fund outflows", Journal of Financial Economics, vol. 97(2), pp. 239-262.

Chernenko, S. and Sunderam, A., 2016. "Liquidity Transformation in Asset Management: Evidence from the Cash Holdings of Mutual Funds," Fisher College of Business Working Paper No. 2016-03-05, Charles A. Dice Center Working Paper No. 2016-5.

Center for Research in Security Prices. CRSP Survivor-Bias-Free US Mutual Fund Database.

Coval, J. and Stafford, E., 2007. "Asset fire sales (and purchases) in equity markets," Journal of Financial Economics, vol. 86(2), pp. 479-512.

Falato, Antonio, Ali Hortaçsu, Dan Li, and Chaehee Shin. "Fire-Sale Spillovers in Debt Markets," The Journal of Finance, forthcoming.

Goldstein, I., Jiang H., and Ng, D. T., 2017. "Investor flows and fragility in corporate bond funds," Journal of Financial Economics, vol. 126(3), pp. 592-613.

Morningstar, Inc. Morningstar Direct, http://corporate.morningstar.com/US/asp/subject.aspx?xmlfile=40.xml.