Private Safe-Asset Supply and Economic Instability (draft)
I study the macroeconomic implications of an increase in safe-asset demand by exploring the interplay between the private safe-asset supply and the quality of investments. I consider a setting in which risk-neutral bankers (i) raise funds from households by issuing safe claims, (ii) invest the proceeds into risky investment projects, and (iii) exert unobservable effort to improve the quality of the projects. Bankers can transform risky cash flows into safe claims through diversification, i.e., by trading financial claims with other bankers. The amount of safe claims that a banker can issue depends on the level of diversification and on the effort exerted, giving rise to a natural tension: While diversification requires the sale of cash flows to other bankers, exerting effort requires cash flows retention to provide incentives. I show that, in this setting, an increase in the demand for safe assets depresses aggregate output and increases economic volatility. The reason is that bankers respond to the increase in demand by diversifying more cash flows at the expense of reducing effort, and therefore reducing the quality of the projects. How safe assets are manufactured, i.e., the types of financial claims that bankers can trade with each other, is essential for assessing the normative properties of the decentralized equilibrium. While complete markets implement the constrained efficient allocation, incomplete markets (e.g., securitization and late-asset sales) exacerbate the negative effect of increased safe-asset demand on economic fundamentals, calling for policy intervention.
Safe Assets in the Long-run International Perspective (Dmitry Kuvshinov, Björn Richter, and Victoria Vanasco)
This paper uses new data to track the evolution of safe assets in the global financial system, and to study changes in their supply and demand. Safe assets can be supplied by the government (public supply) or by the private sector (private supply), with the private production of safe assets often backed by public safe assets or other private assets. We highlight the key role of the financial sector on both the demand and the supply side of safe assets. This key role extends across borders, with the international financial system rapidly expanding its demand for the US and Euro safe assets over the past three decades.
Understanding the Interplay between Safety and Liquidity
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.