Safety Transformation and the Structure of the Financial System

• DOI: http://doi.org/10.1111/jofi.12967
• Published date: 01 December 2020
• Date: 01 December 2020
• Author: WILLIAM DIAMOND

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 6 •DECEMBER 2020

Safety Transformation and the Structure of the

Financial System

WILLIAM DIAMOND∗

ABSTRACT

This paper studies how a financial system that is organized to efficiently create safe

assets responds to macroeconomic shocks. Financial intermediaries face a cost of

bearing risk, so they choose the least risky portfolio that backs their issuance of risk-

less deposits: a diversified pool of nonfinancial firms’ debt. Nonfinancial firms choose

their capital structure to exploit the resulting segmentation between debt and equity

markets. Increased safe asset demand yields larger and riskier intermediaries and

more levered firms. Quantitative easing reduces the size and riskiness of interme-

diaries and can decrease firm leverage, despite reducing borrowing costs at the zero

lower bound.

AN IMPORTANT ROLE OF FINANCIAL intermediaries is to issue safe, money-

like assets, such as bank deposits and money market fund shares. As an empir-

ical literature has documented (Krishnamurthy and Vissing-Jorgensen (2012),

Sunderam (2015), Nagel (2016)), these assets have a low rate of return that

is strictly below the risk-free rate they would earn without providing mone-

tary services. Agents who can issue these assets therefore raise financing on

attractive terms, capturing the “demand for safe assets” that pushes their cost

of borrowing below that of others. This paper presents a general equilibrium

model of how the financial system is organized to meet this demand for safe

assets and examines how the system as a whole adjusts when the supply or

demand for safe assets changes.

In the model, financial intermediaries create safe assets by issuing riskless

debt (deposits) backed by a diversified portfolio of risky assets. Financial in-

termediaries face an agency cost of bearing risk, so they hold the lowest risk

∗William Diamond is with the Wharton School of the University of Pennsylvania. I thank my

advisors David Scharfstein, Sam Hanson, Jeremy Stein, and Adi Sunderam for their outstanding

guidance and support. I also thank the Editor Philip Bond, two anonymous referees, and discus-

sants Tetiana Davydiuk, John Kuong, and Giorgia Piacentino for very constructive comments as

well as Nikhil Agarwal, Jules van Binsbergen, Douglas Diamond, Emmanuel Farhi, Itay Gold-

stein, Ye Li, Yueran Ma, Nikolai Roussanov, Alp Simsek, Argyris Tsiaras, Jessica Wachter, and

John Zhu for helpful discussions and feedback. I have no conflicts of interest to disclose as identi-

fied in The Journal of Finance disclosure policy.

Correspondence: William Diamond, Wharton School, University of Pennsylvania, 3620 Locust

Walk, Philadelphia, PA19104; e-mail: diamondw@wharton.upenn.edu

DOI: 10.1111/jofi.12967

© 2020 the American Finance Association

2973

2974 The Journal of Finance®

Figure 1. Household and bank balance sheets (2015 Financial Accounts of the United

States).

portfolio that backs their issuance of riskless debt. The size of the financial

sector is determined by the trade-off between the benefit of safe asset creation

and this agency cost of bearing risk. This trade-off determines both the com-

position of intermediary balance sheets and the leverage of the nonfinancial

sector. The lowest risk portfolio of any size containing only risky assets con-

sists of all risky debt issued by nonfinancial firms, with the nonfinancial firms’

leverage chosen optimally. Risky debt securities are held by intermediaries,

while riskless assets and equities are held by households. These asset hold-

ings are broadly consistent with the balance sheets of U.S. commercial banks

and households presented in Figure 1.1

The model provides a framework for analyzing the general equilibrium ef-

fects of changes in the supply and demand for safe assets. If the demand for

safe assets increases, financial intermediaries increase the quantity of safe as-

sets that they supply to clear the market. To back their increased supply of

safe assets, intermediaries therefore buy more debt securities, which, in turn,

induces the nonfinancial sector to increase its leverage. Since 2002, Caballero

and Farhi (2017) document an increased spread between the risk-free rate and

their measure of the expected return on risky assets, caused in part by grow-

ing foreign demand for U.S. safe assets (Bernanke et al. (2011)). As the model

predicts, this growing demand coincided with a large credit boom in the 2000s.

Mortgage payments grew from 5.87% of disposable income in 2003 to a peak

1Household portfolio holdings are based on the assumption that their mutual funds are 70%

equity and 30% debt, consistent with data from the Investment Company Institute’s Investment

Company Fact Book. Bank assets omit life insurance reserves, foreign direct investment, and mis-

cellaneous assets.

Safety Transformation and the Structure of the Financial System 2975

of 7.21% at the end of 2007,2accompanied by growth in the size and riskiness

of the financial sector (Bhattacharyya and Purnanandam (2011)). The model

shows how a scarcity of safe assets may have fueled the risky lending that

occurred in this period, a possible contributor to the financial crisis of 2008.

To stimulate recovery after the crisis, the U.S. FederalReserve began a quan-

titative easing (QE) program that increased the supply of safe assets by provid-

ing riskless bank reserves to financial institutions. In the model, this supply

of reserves crowds out the need for intermediaries to make risky loans to the

nonfinancial sector and reduces the cost for intermediaries to issue riskless

debt. This increases the supply of safe assets, decreases the risk of assets held

by intermediaries, and under some conditions reduces the leverage of the non-

financial sector. This finding is consistent with empirical evidence that QE re-

duced the riskiness of financial institutions (Chodorow-Reich (2014)) and par-

tially mitigates concerns raise by some policymakers (Stein (2012a)) that QE

may have induced firms to issue more risky debt. During the implementation

of QE, interest rates were stuck at the zero lower bound. With a zero lower

bound and nominal rigidities added, the model is also consistent with evidence

that QE led to a drop in long-term and risky interest rates (Krishnamurthy and

Vissing-Jorgensen (2011)). At the zero lower bound, QE stimulates consump-

tion because it lowers the risk-free rate earned by an asset that provides no

monetary services, as documented empirically by van Binsbergen, Diamond,

and Grotteria (2020).

In the model, firms produce all resources by managing a continuum of

projects with exogenous output (Lucas trees). Firms choose whether to buy

a single tree or to act as a financial intermediary that can invest in securities.

Each tree-owning nonfinancial firm chooses to issue (i) as much riskless debt

as possible, (ii) an additional low-risk debt security, and (iii) a high-risk eq-

uity security. Firms are exposed to both aggregate and idiosyncratic risk, and

their idiosyncratic risk implies that the quantity of riskless debt that they can

issue does not entirely meet households’ demand for riskless assets. This gap

provides a role for intermediaries, who buy a diversified portfolio of nonfinan-

cial firms’ low-risk debt that is safe enough to back a large quantity of riskless

deposits with a small buffer of equity capital to bear any systematic risk. In-

termediaries do not buy equities, which are too systematically risky to back

enough riskless deposits. Intermediaries do not buy riskless debt since doing

so would not increase the total supply of riskless assets.

The fact that intermediaries are willing to pay more than households for

low systematic risk assets but less for high systematic risk assets implies that

asset prices are endogenously segmented. The risk-free rate is strictly lower

than that implied by the representative household’s consumption Euler equa-

tion because households obtain utility directly from holding riskless assets

(Caballero and Krishnamurthy, 2009; Krishnamurthy and Vissing-Jorgensen,

2Board of Governors of the Federal Reserve System (U.S.), Mortgage Debt Service Payments as

a Percent of Disposable Personal Income [MDSP]. Retrieved from FRED, Federal Reserve Bank of

St. Louis; https://fred.stlouisfed.org/series/MDSP, December 25, 2019.