Safe Assets As Balance Sheet Multiplier
by Kathy Yuan
London School of Economics
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Risky and information sensitive assets, such as mortgage and bank loans, are often pledged as collateral to overcome the limited commitment problem but they are costly to produce and their funding capacity is limited due to adverse selection. Safe assets, such as reserves and treasury bonds, are free of adverse selection and hence are information insensitive. Safe assets can also be used as collateral but are even costlier to hold than risky assets. We demonstrate a complementarity between the use of safe and risky assets as collaterals. Safe assets facilitate the production of risky collaterals, increase borrowers’ leverage and expand the balance sheet. Complementaries arise because safe assets lower adverse selection and coordinate beliefs in selecting the liquid equilibrium. We allow for joint design of borrowers’ asset and liability and show liquid debt/illiquid equity tranches emerge as optimal liability. In facilitating borrowing safe assets and liquid debts are substitutes, but in the optimal design of the borrower’s balance sheet they are complements. If safe assets become cheaper to hold then the borrower will also hold more liquid debt and vice versa. The theory has implications on the optimal balance sheet (asset-liability) compositions of banks and their role as liquidity producers, excess cash holdings for corporations, and also for monetary and financial policies.