Private Safe Asset Supply and Financial Instability
Draft Feb. 2025 | ECB Research Bulletin | VoxEU article | Submitted
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Abstract. This paper studies the supply of private safe assets by banks and its implications for financial stability. Banks originate loans and improve loan quality through hidden screening efforts. They can then create safe assets by issuing debt backed by the safe payoffs, from the loans they have originated and a diversified pool of loans from other banks. The interaction between banks' screening efforts and diversification decisions determines the volume of safe assets they supply. In the context of incomplete markets, a free-rider problem arises: individual banks fail to internalize how their efforts influence the ability to generate safe assets through diversification, as this depends on the collective efforts of all banks. This market failure creates a novel inefficiency, which worsens as the scarcity of safe assets increases, leading to a backward-bending safe asset supply curve, and underscoring the need for policy. The public provision of safe assets helps mitigate the inefficiency by reducing their scarcity, but it cannot fully solve the problem. Moreover, the impact on the total private supply of safe assets is ambiguous: public safe assets reduce incentives for diversification (a "crowding-out" effect), which in turn increases banks' incentives to exert screening effort (a "crowding-in" effect).​​
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Sectoral Dynamics of Safe Assets in Advanced Economies (with Dmitry Kuvshinov, Björn Richter, and Victoria Vanasco)​​
Draft May 2025 | CEPR Discussion Paper DP19025 | VoxEU article | Submitted
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Abstract. What is the sectoral composition of the market for safety, and does it matter for economic stability? To address these questions, we construct a novel dataset of sectoral safe asset positions in 21 advanced economies since 1980. In almost every country, safe assets have grown considerably relative to GDP, while maintaining a stable “safe-asset share” relative to total financial assets. We find that safe-asset fluctuations are almost exclusively driven by the foreign and financial sectors—who are, respectively, the key marginal buyers and issuers of safe assets—with the real and public sectors playing a muted role. Moreover, increases in safe asset demand by foreigners (raw, and instrumented using emerging-market FX holdings)—or its counterpart, the supply by financials—are associated with expansions in domestic risky credit and lower medium-term output growth. Our results suggest that advanced economies have been increasingly intermediating safety within and across borders, with potentially adverse effects on their economic stability.
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A Theory of Bank Liquidity Requirements (with Charles W. Calomiris, Florian Heider and Marie Hoerova)
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Abstract. We develop an asset-side theory of bank liquidity requirements, which focuses on the risk-management gains from requiring cash reserves. The key role of cash in the bank is to attenuate the banker's moral hazard. Because cash is observable and riskless, its value does not depend on the banker's risk management effort. Greater cash holding improves bank incentives to manage risk in the remaining, non-cash, portfolio of risky assets. Because cash is ring-fenced from moral hazard, it serves as a form of collateral to bank creditors. We allow cash to be generated either initially from the funding of the bank or subsequently by selling risky assets in the market. But buyers of risky assets have limited aggregate resources, which generates a fire-sale discount on risky assets sold by the bank to generate cash. The fire-sale externality leads to a wedge between privately-optimal and socially-optimal liquidity holdings, requiring regulation of bank cash holdings to address the externality. More equity capital ex ante also improves risk management incentives but cash can be complementary to equity because it can be generated in the bad state, at the time when it is hard or impossible for a bank to raise more equity. Our theory has several implications for the design of liquidity regulation that are absent from existing regulation.
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Understanding the Interplay between Safety and Liquidity
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The literature often takes for granted that safe assets are liquid, and even if this premise builds on a strong empirical foundation, assuming this relation always holds ignores important financial fragilities. I empirically assess the interplay between the safety and liquidity characteristics of an asset, by using COMPUSTAT data and bond level data provided by Refinitv to construct measures of default risk and liquidity at the bond level. Following the corporate bankruptcy literature, I use two measures of default risk: (i) Alltman’s Z score which is an index constructed using balance sheet data, and (ii) Merton’s probability of default, to calculate the market value of assets by viewing the observed equity price as a call option on the unobserved market value of the entire firm. Regarding the liquidity measure, I use the standard bid-ask spread. I study how the correlation between these two measures evolve over time, and with economic and institutional conditions.
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