Madalen Castells-Jauregui
- 27 May 2025
- RESEARCH BULLETIN - No. 131Details
- Abstract
- This article 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 both 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 internalise 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. 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).
- JEL Code
- G20 : Financial Economics→Financial Institutions and Services→General
G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation
- 26 March 2025
- WORKING PAPER SERIES - No. 3044Details
- Abstract
- This paper analyzes the private production of safe assets and its implications forfinancial stability. Financial intermediaries (FIs) originate loans, exert hidden effort toimprove loan quality, and create safe assets by issuing debt backed by the safe paymentsfrom (i) their own loans and (ii) a diversified pool of loans from all intermediaries. Ishow that the interaction between effort and diversification decisions determines theaggregate level of safe assets produced by FIs. In the context of incomplete markets, Iidentify a free-rider problem: individual FIs fail to internalize how their effort influencesthe ability to generate safe assets through diversification, since the latter depends onthe collective effort of all FIs. This market failure generates a novel inefficiency, thatworsens as the scarcity of safe assets increases. The public provision of safe assetshelps mitigate this inefficiency by reducing their scarcity, but it cannot fully resolve it.Moreover, the impact on the total private supply of safe assets is ambiguous: public safeassets reduce incentives for diversification (crowding-out effect), which in turn increasesFIs’ incentives to exert effort (the crowding-in effect).
- JEL Code
- G20 : Financial Economics→Financial Institutions and Services→General
G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation