Safe assets: a review

We survey the emerging literature on safe assets. The recent evidence on a time-varying safety premium suggests a demand for safety quite distinct from liquidity and classic money demand, offering insight on a strong segmentation between safe savings and speculative investment markets. A related theoretical literature studies the private creation of (quasi) safe assets by intermediaries, shedding new light on bank intermediation and financial stability. Novel concepts such as maturity races, information sensitivity, risk-intolerant debt and induced runs reinforce the liquidity risk externality associated with banking, and have significant implications for research on credit cycles as well as for prudential policy. ECB Working Paper 2035, March 2017 1 Non-Technical Summary The recent banking crisis was largely unanticipated, and has forced a major reassessment of views on risk creation. It has led to a recognition that major fluctuations are not just driven by real shocks, as credit is not just determined by real factors and that credit cycles differ from traditional business cycles. The macro and finance research agendas are seeking a more integrated framework to describe the evolution of aggregate endogenous risk. There appears to be a clear division of tasks. New macro models study the dynamics of economic propagation of financial shocks under financial constraints. Financial research looks at how risk incentives shape the distribution of shocks and how contracts redistribute their impact. Novel concepts such as maturity races, volatility spirals, information sensitivity, induced runs and correlated risk strategies have come to enrich our understanding of excess risk creation over the financial cycle. These new insights complement the established notion of the liquidity risk externality associated with banking. The paper reviews an important new strand in the literature, the recognition of a fundamental demand for safety, distinct from liquidity and money demand. This novel insight has the potential to induce a major theoretical reassessment in macro and banking theory. The survey reviews the evidence for demand for safety, and its pricing and market segmentation implications. The theoretical overview considers also the new work on the nature and consequences of safe asset demand. It recognizes its role in shaping contracting and the structure of financial intermediation. It describes how demand factors lead to autonomous changes in private supply of (quasi) safe assets, and thus the volume of credit independently from real factors. Finally, the survey considers the critical issue whether pressure for safety contributes to aggregate risk. The answer is clearly positive. A segmented demand for absolute safety produces risk intolerance and extreme sensitivity of funding flows to even limited risk. It enables to interpret the specific forms of financial innovation during the credit boom, when novel forms of tranching, funding and hedging were developed to produce a massive amount of quasi-safe assets. The review describes recent theoretical advances highlighting how pressure to satisfy this safety demand, a source of very cheap funding, leads to contractual forms that ultimately create and propagate fragility. The survey concludes with useful insights for financial stability and regulatory policy emerging from the literature. ECB Working Paper 2035, March 2017 2