Private safe-asset supply and financial instability

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 Classification: G20, G28