Supply of Private Safe Assets: Interplay of Shadow and Traditional Banks

We show that the creation of private safe assets by shadow banks can crowd out traditional banks' supply of safe assets. The 2014-2016 money market fund reform created a large demand shock for government- or government-like safe assets. Shadow banks responded and in particular, Federal Home Loans Banks (FHLBs) increased their issuance of short-term safe debt and their lending to banks. To manage their interest rate risk, FHLBs changed the terms of their lending; the new loans had a shorter maturity and reset the interest rate at a high frequency. Depending on their interest rate risk-management, banks differed in their borrowing from FHLBs. We use this differential borrowing in response to the money market reform to study the effect of increased supply of safe assets by FHLBs on banks' balance sheets. We find that banks use FHLB borrowing as a perfect substitute for deposit financing. The substitution of safe debt with FHLB borrowing does not go along with an overall increase in the balance sheet and therefore has no lending effect. This finding has important implications for the transmission of monetary policy as well as broader economic activities. If shadow banks create safe assets at the expense of traditional banks' deposits, then there will be a minimal effect on the total funding available for households and firms from banks and shadow banks.