Safety Transformation and the Structure of the Financial System

Abstract

This 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.

A Macroeconomic Model With Financially Constrained Producers and Intermediaries

“…The setting is simpler since their focus is theoretical; ours is quantitative. As noted, Diamond (2020) provided a micro‐foundation for this balance sheet separation.…”

“…66 Costly state verification models also justify the existence of financial intermediaries who avoid the duplication of verification costs, as in Williamson (1987), Krasa and Villamil (1992), Diamond (1984). Diamond (2020) showed how financial intermediaries arise endogenously when safe assets are scarce. Intermediaries make risky loans to non‐financial firms and transform them into safe assets they issue to households.…”

Quantitative Easing In Overcoming the Crisis: Criticism ofQeinthe Monetary System Of Capitalism

“…Research on Quantitative Easing (hereinafter abbreviated as QE) has been conducted by many researchers, both qualitatively and quantitatively. Most of the research on the influence and impact on inflation and other macroeconomic instruments such as; interest rates, unemployment, and gross domestic product (Ajah et al, 2020;Diamond, 2020;Perillo & Battiston, 2020;Ramkumar & Bates, 2020;Taghizadeh-Hesary et al, 2020). Min-Ho Nam concluded from his quantitative research that quantitative easing (QE) policies in developed countries such as the United States, Japan, Europe, and the United Kingdom have effectively helped lower inflation through the exchange rate channel, while if using trade channels the influence on inflation is insignificant (Bartkiewicz, 2020;Blattner & Joyce, 2020;De Santis & Holm-Hadulla, 2020;Tanaka, 2020;Ward, 2020).…”

“…It is also a major criticism of madzab's critical economist, Jamal Harwood who argues that during the 4 years of quantitative easing (QE) policy in the USA did not fix anything, except for the pseudo-unemployment decline, but inflation soared. The policy is to print more and more money from nothing Financial sector economic analysts (JP Morgan and Credit Suisse) London, United Kingdom, (Ajah et al, 2020;Diamond, 2020;Perillo & Battiston, 2020;Ramkumar & Bates, 2020;Taghizadeh-Hesary et al, 2020). This potential inflansi is also diwarning by Friedman, where the supply of money is not only handed over to the Central Bank.…”

The Financial Origins of Non-Fundamental Risk

“…Relative to this literature, we are closest to Cass and Shell (1983) since asset markets in our economy are complete for all agents who can participate. 7 While this literature focuses on describing conditions un-6 Relatedly, Diamond (2020) shows how an exogenous increase in demand for safe assets can increase riskiness of financial intermediaries' portfolios in a model where financial intermediaries emerge endogenously. Segura and Villacorta (2020) shows that safe asset creation can increase the risk of originated loans.…”