Safe Assets Research Articles

The evolution of European economic institutions during the COVID-19 crisis.

This article argues that the incomplete economic and institutional integration of the euro area has exposed the monetary union to increasing economic divergence, which could be deepened by the COVID‐19 crisis. We discuss how monetary and fiscal measures implemented at the onset of the pandemic have contributed to mitigate the economic consequences of lockdowns, but provided limited insurance to narrow economic gaps across member countries. However, EU countries agreed on July 21, 2020 to develop, for the first time, countercyclical fiscal transfers financed by common debt issuance. We discuss the potential of this instrument to contribute to improve the resilience of the eurozone.

Portfolio rebalancing and the transmission of large-scale asset purchase programs: Evidence from the Euro area

The European Central Bank's large-scale asset purchase program targeted safe assets, but also aimed to impact prices of risky assets. The mechanism for this is the “portfolio rebalancing channel”, where financial institutions’ portfolio decisions impact financial prices more broadly. We examine this mechanism using cross-sectional heterogeneity in how the financial portfolios of different sectors of the European economy were affected around the purchase program. We find evidence of rebalancing. In vulnerable countries, where macroeconomic unbalances and relatively high risk premia remained, we document rebalancing towards riskier securities. In less vulnerable countries, based on granular information for large European banks, we document rebalancing toward bank loans.

Does Integration in the Asian Frontier, Emerging, and Developed Stock Markets Conceal a Hidden Opportunity for Portfolio Diversification?

In the current scenario where Asian markets are growing at an enormous rate, they present a lucrative opportunity for investors to reap better rewards. However, the steep rise in the interdependencies of the markets within the Asian belt has made the investment scenario complex for investors. This study examines the integrated behavior of frontier, emerging, and developed stock markets in Asia. The study used unconditional correlation analysis and a VAR framework for the period ranging from August 1, 2000, to March 31, 2019. In the course of the study, it emerged that the high-level integration between emerging and developed stock markets in this region creates an unfavorable landscape for portfolio diversification. However, there remains an exciting opportunity with safe asset allocation strategies to derive diversification benefits by investing in dynamic and surging Asian frontier stock markets. TOPICS:Exchanges/markets/clearinghouses, developed markets, VAR and use of alternative risk measures of trading risk, portfolio construction Key Findings ▪ The extent of integration between the Asian emerging and developed stock markets has increased and gained greater momentum with the episode of the Global Financial Crisis (GFC). Therefore, there is little/no scope left for portfolio diversification. ▪ In the journey of wealth creation, portfolio investors can concentrate on Asian frontier markets to diversify their portfolio, due to the low integration of these markets with Asian developed and emerging stock markets. ▪ The influencing role of Asian developed markets on emerging stock markets has grown predominant since the GFC. But the notion that developed markets dominate small markets does not hold true in the case of Asian frontier stock markets.

The Stability of Safe Asset Production

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Banking, Trade, and the Making of a Dominant Currency

Abstract We explore the interplay between trade-invoicing patterns and the pricing of safe assets in different currencies. Our theory highlights the following points: (i) a currency’s role as a unit of account for invoicing decisions is complementary to its role as a safe store of value; (ii) this complementarity can lead to the emergence of a single dominant currency in trade invoicing and global banking, even when multiple large candidate countries share similar economic fundamentals; (iii) firms in emerging-market countries endogenously take on currency mismatches by borrowing in the dominant currency; and (iv) the expected return on dominant-currency safe assets is lower than that on similarly safe assets denominated in other currencies, thereby bestowing an “exorbitant privilege” on the dominant currency. The theory thus provides a unified explanation for why a dominant currency is so heavily used in both trade invoicing and in global finance.

Safe-Asset Shortages: Evidence from the European Government Bond Lending Market

AbstractWe identify the unique role of the government bond lending market in collateral transformation during periods of market stress. Using a novel database, we provide evidence that safe assets in the lending market have higher demand, higher borrowing cost, and higher usage of noncash collateral relative to nonsafe assets during stressed market conditions. Moreover, we find that market participants are able to obtain safe assets using relatively low-quality noncash collateral, allowing for collateral transformation. We show that policy interventions by central banks can help reduce safe-asset shortages by returning sought-after safe assets to the market.

The causes and challenges of low interest rates: insights from basic principles and recent literature

PurposeWhat causes the downward trend of real interest rates in major developed economies since the 1980s? What are the challenges of the near-zero interest and inflation rates for monetary policy? What can the policymakers learn from the latest developments in the monetary and interest rate theory? This paper aims to answer these questions by reviewing both basic principles of interest rate determination and recent academic and policy debates.Design/methodology/approachThe paper critically reviews the explanations for the downward trend of real interest rates in recent decades and monetary policy options in a near-zero interest rate environment.FindingsThe decline of real interest rates is likely an outcome of multiple technological, social and economic factors including diminished productivity growth, changing demographics, elevated tail-risk concerns, time-varying convenience yields of safe assets, increased global demand for safe assets, rising wealth and income inequality, falling relative price of capital, accommodative monetary policies, and changes in industry structure that alter the investment and saving behaviors of the corporate sector. The near-zero interest rate limits the space of central banks' response to economic crises. It also challenges some conventional wisdoms of monetary theory and sparks radically new ideas about monetary policy.Originality/valueThis survey differs from the existing work by taking a broader view of both economics and finance literature. It critically assesses the economic forces driving the global decline of real interest rates through the lens of basic principles and empirical evidence and discusses the merits and limitations of each proposed explanation. The study emphasizes the importance of a better understanding of economic forces driving diverging trends of corporate investment and saving behaviors. It also discusses the implications of the neo-Fisherism and the fiscal theory of price level for monetary policy in a low interest rate environment.

Mutual fund asset allocation during COVID-19

The paper examines the investment decisions of equity mutual funds during various stages of the COVID-19 pandemic with monthly portfolio holdings. We find that funds have favored firms with lower risk, higher financial flexibility, and larger asset size during the early months of the pandemic. This preference for relatively less risky firms, which later reverses, suggests a reallocation towards safer assets given the higher uncertainty at the beginning of the crisis. We also find that funds preferred growth firms over value firms as value firms with greater invested capital are likely to be less resilient to the crisis-induced shock. Institutional investors have also favored group-affiliated firms throughout the crisis, reflective of their ability to negotiate through the protracted economic shock. Furthermore, our fund-level analysis reveals that the investment approach of funds strongly varied by the extent of the net fund flows. The paper brings out key firm- and fund-level characteristics that impact the asset allocation of institutional investors during extreme market uncertainty.

Bank runs, portfolio choice, and liquidity provision

We examine the portfolio choice of banks in a micro-founded model of runs. To insure risk-averse investors against liquidity risk, competitive banks offer demand deposits. We use global games to link the probability of a run to the bank's portfolio management. Based upon interim information about risky investment, banks liquidate investments to hold a safe asset. This partial hedge against investment risk reduces the withdrawal incentives of investors for a given deposit rate. As a result, (i) banks provide more liquidity ex ante (so banks offer a higher deposit rate) and (ii) the welfare of investors increases. Our results highlight the management of both sides of a bank's balance sheet and a complementarity in the two forms of insurance that banks provide to investors.

Fiscal and financial conditions for a stronger euro area

The euro is irreversible but it needs reform to address well-known design deficiencies and also new challenges. Although progress has been made, further steps are needed, the most important of which are: revision of the fiscal rules, establishing a central stabilisation capacity, and completing the banking union (especially a deposit insurance, a capital market union based around a common safe asset, and improved macroprudential policy). This article sets out the necessary reforms in these areas in detail.

The Safety Trap: Coordination of Monetary and Fiscal Policies

Is expanding balance sheets in the normal a correct approach? Do balance sheet policies provide a much needed new instrument for central banks? In this paper I argue that not necessarily. I show that assuming that the safety trap is a primary reason for low interest rates, some balance sheet policies do not address the problem. The potential approach of a coordinated response of fiscal and monetary policies can address the issue. Applying a game-theoretic approach, I show that the equilibrium achieved by monetary and fiscal authorities acting independently indeed implies undersupply of safe assets leaving output below its potential level. This brings a new perspective on the coordination of monetary and fiscal policies.

Liquidity from Two Lending Facilities

During financial crises, the lender of last resort (LOLR) uses lending facilities to inject critical funding into the banking sector. The facilities need to be designed in such a way that banks are not reluctant to seek assistance due to stigma and that banks with liquidity concerns are attracted rather than those prone to risk-taking and moral hazard incentives. We use an unexpected disclosure that introduced stigma at one of two similar LOLRs during the Great Depression to evaluate whether banks used LOLR assistance to improve their liquidity needs using a novel trivariate model with recursive endogeneity. We find evidence that banks that approached the facility with stigma were less liquid and reduced their position of safe assets in comparison with banks that approached the facility with no stigma. Thus, stigma forced the pool of LOLR borrowers to separate into different groups of banks that ex-post revealed their liquidity preferences. This finding sheds light on why and when banks approach their LOLR.

Investor Sophistication and Portfolio Dynamics

We develop a simple dynamic general-equilibrium framework that can jointly rationalize many empirically observed features of household portfolios, investment returns, and wealth dynamics. The model differs from traditional models only along a single, natural dimension: households differ in their confidence about the return processes for risky assets. Less-confident households (but with unbiased beliefs) overinvest in safe assets, hold underdiversified portfolios concentrated in familiar assets, are trend chasers, and earn lower absolute and risk-adjusted investment returns. More confident households hold riskier positions and exhibit superior market-timing abilities. Despite Bayesian learning, this investment behavior persists for long periods, thereby exacerbating wealth inequality.

The Quest for a European Safe Asset—A Comparative Legal Analysis of Sovereign Bond-Backed Securities, E-Bonds, Purple Bonds, and Coronabonds

The European sovereign debt crisis and, more recently, the COVID-19 pandemic have revealed the European Economic and Monetary Union’s fragility, which essentially emanates from the inherent tension between a single monetary policy and decentralized fiscal policies. To cushion economic and financial shocks and sever the sovereign-bank doom loop, different proposals to create a common public debt security have been put forward, although none of them has so far seen the light of day. Building on pertinent economic and finance scholarship, this article reviews four promising safe asset proposals from a legal perspective: Sovereign bond-backed securities (SBBS), E-bonds, Purple bonds, and Coronabonds. Rather than focusing on their feasibility under EU law or national constitutional law, this article compares the proposals from an investor perspective against the backdrop of the following formal and functional legal characteristics that render assets ‘safe’: governing law, dispute settlement forum, investor protection, and investor representation in sovereign debt restructurings. Against this backdrop, targeted recommendations on critical design elements of safe assets, with the aim of reconciling the economic policy objectives with the pertinent legal constraints, are advanced.

Safety Transformation and the Structure of the Financial System

ABSTRACTThis 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 riskless 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 intermediaries and can decrease firm leverage, despite reducing borrowing costs at the zero lower bound.

State-dependent fiscal multipliers with preferences over safe assets

I examine the effect of fiscal policy at the zero lower bound when households have preferences over safe assets (POSA) parameterized consistent with microeconomic evidence on intertemporal choices and the macroeconomic elasticity between US government debt supply and bond yields. POSA loosen the link between household consumption and permanent-income, and imply a wealth effect from government bonds. Therefore, the multiplier of a permanent expenditure change increases. I show that these conclusions carry over to an estimated DSGE model. POSA improves the empirical fit of the model if the dataset includes forward interest rates on top of fiscal and macroeconomic data.

Dollar Safety and the Global Financial Cycle

US monetary policy has an outsized impact on the world economy, a phenomenon that Rey (2013) dubs the global financial cycle. Changes in the US dollar also have an outsized impact on the world economy, while shocks in foreign countries have smaller impacts on the U.S. We build a model to rationalize these facts stemming from the special demand for dollar safe assets. In the model, dollar safe assets trade at a premium; that is, they offer especially low returns. Banks and firms that have the collateral to issue dollar safe assets can collect this premium. Institutions in the U.S. do so against dollar collateral, while institutions in foreign countries do so against local currency collateral, but in the process take on exchange rate risk. Changes in U.S. monetary policy impact the supply of dollar safe assets, but do not offset shocks to safe asset demand. Shocks to U.S. monetary policy and shocks to the value of the dollar transmit across the globe and are a global risk factor. We present evidence from movements in the Treasury basis that support the mechanism underlying our theory.

중국경제정책 불확실성의 장기국채 수익률에 대한 영향 분석

The purpose of this study is to analyze how the increase in economic uncertainty affects the flow of funds in the financial market from the perspective of the current time when Chinese economic uncertainty is growing again. More specifically, this study aims to analyze the relationship between treasury bond yield and economic policy uncertainty to assess whether the uncertainty has an impact on the long-term treasury bond through the preference for safe assets. Two possibilities exist. The first is that, with the growth and development of the Chinese financial economy, it has developed substitutability between risky assets represented by stocks, especially long-term treasury stocks and safe assets represented by treasury bonds. The second is that, although China’s bond market is world’s the second or third largest in terms of issued bonds, the transaction volume falls short of this, and participants are limited, resulting in insufficient market supply and transaction with prices not fully reflecting such information. Therefore, this study aims to verify which of these two possibilities is correct through empirical analysis. This study confirms that, although the Chinese bond market is still immature in terms of trading volume and market participation, long-term government bond yields respond due to the preferences for safe assets caused by the increasing economic uncertainty.

The Impact of Monetary Policy on the Specialness of U.S. Treasuries

I estimate the causal effect of monetary policy on the specialness of U.S. Treasuries. Measuring this specialness using the U.S. Treasury Premium, which is the difference in the convenience yield of U.S. Treasuries and that of government bonds of other developed countries measured as the deviation from covered interest parity between government bond yields, I find that monetary tightening by the Federal Reserve increases the specialness of U.S. Treasuries primarily by increasing the convenience yield of U.S. Treasuries. I also find that the magnitude of the impact varies across the term structure and across countries, especially after the GFC, and U.S. and foreign monetary policy shocks have asymmetric impacts on the specialness of U.S. Treasuries. These results provide evidence for the unique ability of the Federal Reserve to affect the specialness of U.S. Treasuries by altering the supply of dollar safe assets.

On utility maximization under model uncertainty in discrete‐time markets

AbstractWe study the problem of maximizing terminal utility for an agent facing model uncertainty, in a frictionless discrete‐time market with one safe asset and finitely many risky assets. We show that an optimal investment strategy exists if the utility function, defined either on the positive real line or on the whole real line, is bounded from above. We further find that the boundedness assumption can be dropped, provided that we impose suitable integrability conditions, related to some strengthened form of no‐arbitrage. These results are obtained in an alternative framework for model uncertainty, where all possible dynamics of the stock prices are represented by a collection of stochastic processes on the same filtered probability space, rather than by a family of probability measures.