Private Safe-Asset Supply and Financial Instability

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I study the determinants of private safe asset supply and its implications on economic stability in a theoretical framework. The model builds on the documented tension between financial intermediaries' risk sharing activities and the quality of their investments due to a moral hazard problem. The interplay between these two determinants shapes the supply curve of safety and provides an important insight: along the upward-sloping curve, the risk-sharing activity intensifies, jeopardising the incentives to enhance the quality of the investment, deteriorating the expected output and amplifying economic volatility. Thus, the real costs of safe asset supply are particularly acute in the current environment in which safe assets are scarce, an their price is high. Incomplete markets, i.e., the lack of a full set of state-contingent claims, hinders financial intermediaries' ability to cope with the informational friction, and reveals a novel source of inefficiency that calls for policy intervention. The analysis further highlights the need to understand the interaction between different forms to ensure safety for an adequate and effective policy response.​

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Safe assets, capital flows, and macroeconomic outcomes

(with Dmitry Kuvshinov, Björn Richter, and Victoria Vanasco)​

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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 24 advanced economies since 1980. We document that the ratio of safe to total financial assets has remained stable in most countries, despite considerable growth in gross and net safe-asset positions relative to GDP. We find that fluctuations in safe asset positions are mainly driven by the financial and the foreign sectors, with the real economy playing a muted role, indicating that financials in advanced economies have been increasingly intermediating safety within and across borders. We conclude by showing that increases in safe asset demand by foreigners – or its counterpart, the supply by financials,– are associated with expansions in domestic risky credit and lower subsequent output growth.

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A Theory of Bank Liquidity Requirements 

(with Charles W. Calomiris, Florian Heider and Marie Hoerova)

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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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