Private safe-asset supply and financial instability

This paper analyzes the private production of safe assets and its implications for financial stability. Financial intermediaries (FIs) originate loans, exert hidden effort to improve loan quality, and create safe assets by issuing debt backed by the safe payments from (i) their own loans and (ii) a diversified pool of loans from all intermediaries. I show that the interaction between effort and diversification decisions determines the aggregate level of safe assets produced by FIs. In the context of incomplete markets, I identify a free-rider problem: individual FIs fail to internalize how their effort influences the ability to generate safe assets through diversification, since the latter depends on the collective effort of all FIs. This market failure generates a novel inefficiency, that worsens as the scarcity of safe assets increases. The public provision of safe assets helps mitigate this inefficiency by reducing their scarcity, but it cannot fully resolve it. Moreover, the impact on the total private supply of safe assets is ambiguous: public safe assets reduce incentives for diversification (crowding-out effect), which in turn increases FIs' incentives to exert effort (the crowding-in effect).