Federal Reserve Warns of Rising Liquidity Risks in Bank Loan Funds
Washington, Thursday, 20 August 2026.
A new Federal Reserve report reveals that hard-to-sell assets in bank loan mutual funds have reached levels last seen during the 2020 pandemic, raising systemic financial risks.
Understanding Liquidity Transformation and the Fed’s Warning
On August 19, 2026, the Federal Reserve Board of Governors released an updated analysis highlighting a critical structural vulnerability in the financial system: the growing liquidity transformation risks within U.S. bank loan (BL) and high-yield (HY) mutual funds [1][3]. Liquidity transformation occurs when open-end mutual funds offer investors daily redemptions while holding underlying assets that require significantly longer to sell without causing a severe price impact [1][2]. This structural mismatch can trigger systemic fire sales during periods of severe market stress, carrying broad macroeconomic implications for corporate credit markets and credit availability [1].
New Metrics and Shifting Fund Dynamics
To track these vulnerabilities, Federal Reserve researchers Kenechukwu Anadu, Sean Baker, Fang Cai, Logan George, and Erik Larsson updated the metrics originally established in a 2019 study by Anadu and Cai [1][2]. Utilizing granular SEC Form N-PORT data available since 2020, the researchers expanded their analysis to cover all BL and HY mutual funds [1]. They also broadened the liquidity ratio numerator to include highly liquid assets such as cash, cash equivalents, U.S. Treasury Bills, and Short-Term Investment Vehicles (STIVs) [1].
Rising Illiquidity in Bank Loan Funds
A key finding of the Federal Reserve’s update is the growing illiquidity within Bank Loan mutual funds [1][2]. The median liquidity ratio for these funds peaked at nearly 10% of net assets in 2021 before stabilizing at approximately 4.5% since 2024 [1]. However, their median illiquidity ratio—measured by Level 3 assets—has risen steadily, nearing levels last seen during the market panic at the onset of the March 2020 COVID-19 pandemic [1][2]. The researchers noted that this specific dynamic of stable liquidity ratios paired with rising illiquidity ratios suggests an overall increase in liquidity transformation risk for bank loan funds [1][2].
Lessons from Past and Recent Market Shocks
The Federal Reserve’s report evaluated how these funds performed during historical stress events, specifically contrasting the March 2020 pandemic onset with the tariff-induced market volatility of the April 2025 ‘Liberation Day’ shock [1]. During the March 2020 shock, BL funds with below-median liquidity buffers experienced much larger net outflows of 14.2% compared to the 6.7% outflows seen in above-median funds [1]. This historical pattern supported the conventional view that holding larger liquid asset buffers effectively cushions funds against aggressive redemption runs [1].