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• Examines the impact of cash holdings on mutual fund returns using daily data. • Highlights inefficient cash utilization leading to diminished profits in mutual funds. • Emphasizes the need for advanced liquidity management tools in mutual funds. • Suggests balanced regulatory approaches for cash holding and transparency in mutual funds. Mutual funds have traditionally attracted retail investors seeking diversified market exposure. While the focus has historically been on asset liquidity and quality, recent attention has turned to assessing fund liquidity and the risks of asset fire sales. Our study analyzes Israeli mutual funds' daily holdings and flows over an extensive eight-year period, revealing a significant issue: fund managers tend to maintain excessive cash levels, burdening the industry by more than 2 % of assets under management (AUM). These findings highlight the urgency of implementing advanced liquidity management tools to navigate redemption risks effectively. Moreover, our research stresses the need for flexible, market-oriented regulations and enhanced industry transparency. By establishing liquidity risk management guidelines, regulators can optimize investor returns and mitigate potential systemic risks associated with cash allocations in mutual funds. [ABSTRACT FROM AUTHOR]

• We propose a new model to reflect effects of risk-based capital rules on volatility. • The regulator imposes dynamic limits on the asset risk of financial institutions. • Volatility is reduced when capital cushion becomes too small (leverage too high). • Regulation reduces cost of deposit insurance, credit spread, and default probability. • Merton (1974) , Black and Cox (1976) are special cases of our dynamic volatility model. Unlike non-financial firms, financial institutions are often heavily regulated to prevent bankruptcies and negative spillovers. A main regulatory tool is risk-based capital requirements. To reflect this reality, we develop a model that allows for dynamically updated asset risk, in contrast to standard contingent claim models that assume constant volatility. Regulators impose a decrease in asset volatility when the capital cushion becomes small, thereby reducing the risk of distress. We show that such regulation of financial institutions affects their credit spreads, credit ratings, transition matrices, valuation of liabilities, cost of deposit insurance, and risk-shifting incentives. [ABSTRACT FROM AUTHOR]