Savings Gluts and Financial Fragility

Abstract

We investigate the effects of an increase in liquidity (a glut ) on the incentives to originate high quality assets, and on the fragility of the financial sector. Originators incur private costs when originating high quality assets. Assets are subsequently distributed in two markets: A private market where informed intermediaries operate, and an exchange where uninformed investors trade. Uninformed investors pay the same price irrespective of the quality of the assets, which discourages good origination. Informed investors identify and pick the best assets by offering a premium over the uninformed price, which encourages originators to supply good assets. We show that there is a positive origination effect of an increase in savings of uninformed investors when the overall level of savings is low, but the opposite is true when liquidity is abundant, so that an increase in savings has a non-monotone effect on origination incentives. Leverage increases monotonically with savings and is highest precisely when incentives for good asset origination are at their lowest. Thus plentiful liquidity leads to fragile balance sheets: On the asset side non-performing assets accumulate and on the liability side more of those assets are funded with debt. We relate our findings to some of the stylized facts observed in financial markets in the lead up to the Great Recession.