Private Safe-Asset Supply and Economic Instability (draft)
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.
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.