Guiding Seminar 5 Flashcards
The safe assets shortage conundrum
What is a safe asset? What are the characteristics of a safe asset?
A safe asset is a simple debt instrument that is expected to preserve its
value during adverse systemic events.
Safe assets’ characteristics implicit in the definition:
o Safe assets can be transacted without concern for adverse selection (information insensitivity)
o Safe assets have special value during economic crises (“simple” asset)
o Asset is safe if other expect it to be safe (strategic complementarity)
The safe assets shortage conundrum
Who are the suppliers of safe assets?
Suppliers of safe assets: o financial sector (e.g. short-term deposits in banks) o government (e.g. government bonds)
The safe assets shortage conundrum
On what does the capacity of a country to produce safe assets depend on?
Capacity of a country to produce safe assets depends on: o the level of financial development o constraints in the financial system o fiscal capacity of the sovereign o exchange rate and price stability advanced economies, mostly the US Supply of safe assets
The safe assets shortage conundrum
What were the macroeconomic effects on safe asset shortage in 1990-2000 and 2007-2008?
1990s-2000s: safe asset shortage
i) stimulated the financial system to supply AAA-rated
securitized instruments;
ii)made it easy for fiscally weak countries (i.e. Greece) to issue debt at favorable yields
–>increased supply of pseudo-safe assets
——>reduced downward pressure on safe real rates
• 2007-2008: pseudo-safe assets lost their “safe” status
–> the supply of safe assets↓, demand for safe assets↑
—-> safe asset interest rate ↓ reaching its effective lower bound
With real safe rates unable to decrease further to clear markets, demand for safe assets remained too elevated and the economy had to slow down and operate below its potential (modern version of the paradox of thrift).
The safe assets shortage conundrum
What is a safety trap? What are the main differences between a safety trap and a liquidy trap?
An acute shortage of safe assets creates a safety trap
• Differences from a liquidity trap:
o exit from a safety trap requires an increase in the supply of, or a reduction in the demand for, safe
assets, regardless of the demand and supply of other assets
o safety traps can be very persistent or even permanent despite the presence of long-lived assets,
because the risk premia attached to long-lived assets bound the value of these assets and the
associated wealth effects on aggregate demand
The safe assets shortage conundrum
What is the global nature of the safety trap?
Global nature of the safety trap: the scarcity of safe assets in one country spreads to others via capital outflows, until safe rates are equalized across countries
–> the global safe interest rate drops and capital flows increase to restore equilibrium in global and
local safe asset markets. Once the zero lower bound for global interest rates is reached, global output
becomes the adjustment variable
–> interdependence of world economy (since countries can no longer use monetary policy to protect themselves from world capital flows)
The safe assets shortage conundrum
What are the proposed solutions to restore the equilibrium of safe assets?
- Exchange rate appreciation of the currencies of safe asset producers (increased real value of safe assets for non-currency holders). But it depresses net exports and potentially output for safe asset issuers.
- Issuance of public debt –> increases supply of safe assets (government bonds)
- Infrastructure investment (loans)–> boosts growth, increasing fiscal capacity –> maximum issuance of safe assets per unit of installed capital.
- Production of private safe assets (still face systematic risks)
- Reducing the (Net) demand for safe assets
The safe assets shortage conundrum
On what 2 factors does the issuance of public debt depend on?
- The fiscal capacity of the government to borrow
2. The risk that increased provision of public safe assets may crowd out the provision of private-sector safe assets.
The safe assets shortage conundrum
What are the problems associated with the issuance of public debt?
- Can core economies fulfill a growing demand?
And not weaken their fiscal capacity by supplying too many safe assets? - If the safe asset scarcity disappears, the issuers face exploding and unsustainable debt dynamics
- Potential coordination failure
The safe assets shortage conundrum
What are the reasons why private safe assets are still risky? What is the solution to the problem?
Private safe assets are still vulnerable to systematic events and panic.
Solution: some form private-public partnership (providing a fiscal backstop for the severe tail risks of safe private assets, while monitoring collective moral hazard) (hard and inefficient).
The safe assets shortage conundrum
What are the two reasons why banks hold safe assets? And how could they be replaced?
- To be able to intervene in foreign exchange markets if desired (involves hoarding of foreign safe assets–> inefficient insurance mechanism) –> could be partially replaced by more powerful global risk sharing arrangements (swap lines, reserve sharing agreements, etc).
- As a result of quantitative easing policies, which involve the accumulation of domestic safe assets and occasionally riskier ones. –> CBs should not be hoarding safe assets beyond those who are required for the conduct of conventional monetary policy. –> Basel III criteria requires that financial institution hold safe assets on their balance sheets.
Understanding the role of debt in the financial system
What is Pawning? Repo? What are the key differences?
Pawning the watch: 1) parties do not have to agree on the value of the watch → no need for price discovery 2) the broker will offer a price with a big enough haircut 3) the borrower keeps the right to redeem the watch at the same price later
• Repo - a repurchase agreement where a seller of a security agrees to buy it back from a
buyer (investor) at a higher price on a specified date.
• Functional difference between pawning and repo - in pawning the initiative comes from the borrower who has a need for liquidity, while in repo the initiative comes from someone with money who wants to park it safely by buying an asset in a repo
Understanding the role of debt in the financial system
What are the differences between the stock and money markets?
Money markets are used by government and corporate entities as a means for borrowing and lending in the short term (provide liquidity by insuring information symmetry–> both parties have symmetric information about the collateral- e.g. pawn contract).
The stock market refers to the collection of markets and exchanges where the regular activities of buying, selling and issuance of shares of publicly held companies take place.
Stock market: risk sharing, price discovery, information sensitive, transparent, many exchages, volatile volume of trade and trading not urgent.
Money market: liquidity provision/ lending–> no need for price discovery and no need for transparency (opaque = transparent), few trades, trading urgent (for fast liquidity) and stable volume of trade.
Understanding the role of debt in the financial system
What are the two main reasons why debt is an optimal contract?
- Avoids a precise assestment of the collateral value at the time the contract is signed
- Avoids the cost of price discovery whenever debt is paid in full
Understanding the role of debt in the financial system
What are the three senses in which debt is information-insensitive?
- Debt is information-insensitive to private information if it is deep in the money (otherwise migh pay the buyer to acquire information about underlying collateral of debt before buying it).
- Debt is a contract –> do not care about the information acquisition, only care about the payoff.
- Least sensitive to public information (debt is the best collateral).
Understanding the role of debt in the financial system
When is debt more information-insensitive?
- When collateral is less risky
- When duration of debt is reduced
- When FV of debt is reduced
- When more collateral is added
Understanding the role of debt in the financial system
Why woud anyone want opacity (lack of transparancy)?
Examples why transparency may be bad:
o During car auctions buyers are allowed to inspect cars only externally → provides increased speed of the
actions and reduces adverse selection (the value of cars is approximately the same across buyers)
o Money market mutual funds report the Net Asset Value (NAV) only quarterly and with a 1-month lag →
opacity gives MMMFs time to adjust to fluctuations in daily NAV and prevent investors from running
o Coarse bond ratings promote “commonality of beliefs” → result in reduced adverse selection
o Money is very opaque about the underlying collateral because no one knows exactly what backs up
government issued money → all the market participants are “symmetrically ignorant”, which is a blissful state in money markets
o During bubbles no one is likely to have private information about when prices will collapse → symmetric ignorance can make them a safe place to park money, at least for a short period of time
Understanding the role of debt in the financial system
What are the consequences of debt and opacity (lack of transparency) in panics?
- Everything that adds liquidity in good times pushes risk into the tail
- Panics happen when information-insensitive debt becomes information-sensitive
- There is enough uncertainty–> investors begin asking questions about the underlying collateral
- No common belief about the value of debt even though before the panic investors had shared views on pricing
- Fire sales, domino effect, interlinked balance sheets–> all contribute to the state of panic
- Hard to understand what drives what
Understanding the role of debt in the financial system
What is shadow banking?
[lending and other financial activities conducted by unregulated institutions or under unregulated conditions]
- The new model of ”originate to distribute” rather than “originate to hold”
- Shadow banking is highly scalable → designed to manufacture large amounts of high-quality assets, which are more widely acceptable
- State-contingent use of capital is more efficient than keeping mortgages on the books of originating banks
What drove the demand for new products and the growth of shadow banking?
• The global savings accumulation → foreign investors perceived the US financial system as a “safe
parking space” for money (global demand for safe assets)
• The US had sophisticated securitization technology that could activate and make better use of collateral (could manufacture a lot of AAA-rated securities provided there is available raw material)
• The US had a large pool of assets: housing (debt-free or underleveraged houses were potential
raw material for securitization )
Understanding the role of debt in the financial system
What two faces do debt and institutions dealing with debt have?
- A quiet one (liquidity and trust prevail because few
questions need to be asked) - A turbulent one (a loss of confidence and a panic may break out)
It is important not to let the recent crisis dominate the new designs → the quiet, liquid state is hugely valuable
Understanding the role of debt in the financial system
What are the solutions for getting out of the crisis?
- Crisis ends when confidence returns–> back to the “no questions asked” state, which involves:
a) recapitalization of the banking system
b) transparency without remedial action is a prescription for disaster
c) the lack of specific information is the key element in the effectiveness of the message (e.g. Draghi’s words “We will do whatever it takes”)
d) a detailed transparent plan to get out of the crisis might lead to a difference in opinions rather than to a convergence of views - Higher capital requirements and regular stress tests is the best road for now (in bad times it is better to be less transparent with stress tests).
The Economics of Structured Finance
What were the reasons for structured market expansion?
- Offered attractive yields in the period of low interest rates and AAA-ratings
- Were rated using the same scales as bonds (easy to compare)
- Strong economic growth and few defaults
- Minimum capital requirement