Private safe asset supply and financial instability

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 Classification: G20, G28