Safe Assets as Collateral Multipliers Emre Ozdenoren Kathy Yuan Shengxing Zhang∗ London Business School London School of Economics London School of Economics CEPR FMG CFM CEPR CEPR March, 2020 Abstract 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. Keyword: Liquidity; Security Design; Financial Fragility; Collateral; Safe Assets, Information- Insensitive Assets; Equilibrium Coordination. JEL classification: G10, G01 ∗Ozdenoren ([email protected]), Yuan ([email protected]), and Zhang ([email protected]). We thank Yue Wu for excellent research assistance. 1 1 Introduction Safe assets in the form of reserves, treasury bills and bonds issued by the government have been viewed to take the following three roles: a medium of exchange, a unit of account and a store of value.1 In this paper, we argue that there is an additional role of safe assets: collateral multiplier. In an environment with limited commitment, risky but information-sensitive assets, such as mortgage and bank loans, are often used as collateral to obtain funding for productive opportunities. However, their funding capacity is limited due to information frictions. By comparison, safe assets are free from information frictions but costlier to produce. We show that by combining safe assets and risky collaterals, productive agents in the economy can improve the funding capacity of their liabilities backed by these assets. We start by studying a static benchmark where borrowers pledge the future cashflows from a portfolio of a safe asset and a risky collateral. By doing so they obtain private liquidity from potential lenders to use as inputs for a productive technology. The risky collateral is subject to adverse selection. It can be high or low quality and this information is privately known by the borrower. We measure the degree of adverse selection by the ratio of expected payoff between low to high quality collateral. When the portfolio consists of only the risky collateral, the equilibrium outcome depends on the degree of adverse selection. If the degree of adverse selection is low (high) relative to the productivity of the real technology then both the high and low quality risky (only the low quality) collaterals are used to generate liquidity which increases (lowers) the average quality of the collateral pool. As a result, uninformed investors are willing to pay a higher (lower) price for the risky collateral and more (less) funding is raised. In this case, we say that the risky collateral is liquid (illiquid). We next demonstrate the collateral multiplier role of the safe asset in this lemons environment. In reality, safe assets are costly to hold for investment (eg., due to value erosion from inflation). To starkly highlight the collateral multiplier role of the safe asset, we assume that its cost is so high relative to the productivity of the real technology that it is unprofitable to use it as collateral on its own. An immediate consequence of this assumption is that the safe asset is not desirable to hold if the risky collateral is liquid. If the risky collateral is illiquid, however, we demonstrate that the safe asset improves the funding environment. By combining the safe asset with the risky collateral in a portfolio, adverse selection is reduced, the economy switches from the illiquid to the liquid equilibrium, resulting in greater funding and real output. That is, by holding the safe asset on its balance sheet, the borrower influences the 1For example, Samuelson (1958) studies money as a store of value in an overlapping- generations model, and Kiyotaki and Wright (1989)study money as a medium of exchange in a model with search frictions. 2 lenders’ beliefs so that they rationally expect both borrower types to be present in the collateral market. Since, borrowers are willing to pay more to hold the safe asset and the risky collateral together in a portfolio, the assets would fetch higher prices jointly, resulting in a safety premium for the safe asset and a liquidity premium for the risky collateral. Further, there is a complementarity in holding both assets. When the cost of holding the safe asset is lower, more of the risky collateral will be held, expanding the borrowers’ balance sheet and increasing pledgeable cashflow in the economy. This finding is supported by the empirical evidence in Adrian and Shin (2014) where they document the expansion of banks’ balance sheet as monetary policy is loosened. So far we have been focusing on the asset side of borrowers’ balance sheet implicitly assuming that the borrower’s portfolio of assets are sold as a single security to raise funding. We next allow borrowers to optimally design the securities on the liability side of the balance sheet. Since these securities are backed by the borrower’s assets, security design opens the door to joint design of the asset and liability sides of the balance sheet. In our setting, optimal security design leads to tranching the liability into a liquid debt tranche that is issued by both the high and low quality borrowers (and hence it is information insensitive), and an illiquid equity tranche issued by only the low type. The debt tranche is a claim to the entire cashflow from the safe asset as well as the cash flow from the risky collateral up to a threshold. This threshold is chosen so that the high quality borrower is indifferent between selling the debt versus not. The liquid debt tranche is, hence, risky since it is subject to default. The interesting element of this design is the interaction between the two liquid instruments: the safe asset on the asset side and the liquid debt tranche on the liability side of the balance sheet. The safe asset can be considered as public liquidity (since safe assets are normally produced by the government) while the liquid debt tranche can be considered as private liquidity. In this way, our theory applies naturally to banking. The asset side of the banks’ balance sheet consist of safe assets such as reserves, and risky assets such as bank loans. The liability side consists of liquid short-term debt such as bank deposits and wholesale securitized products. Private liquidity production via the liquid debt tranche substitutes for the high cost of safe asset holding and lowers the funding cost in the economy. Without securitization, borrowers need to hold enough of the safe asset to make the entire asset portfolio liquid. With securitization, they are able to reduce the safe asset holding since only the debt tranche needs to be liquid. Private liquidity producing agents, such as banks, are hence able to economize on their safe asset holding using security design. They hold less of the safe asset per unit of the risky collateral, indicating a substitution effect. At the same time, there is a complementarity between the public and private liquidity. An increase 3 in the safe asset holding makes the cashflow of the debt tranche less information sensitive and reduces adverse selection on the debt tranche. When the bank holds more safe asset, it expands the liquid debt tranche and shrinks the illiquid equity tranche. Hence, by holding more of the safe asset, the bank reduces the implicit cost of holding illiquid liabilities. Conversely, by shrinking the liquid debt tranche and expanding the illiquid equity tranche, the bank can reduce its safe asset holding. Hence, by holding less liquid debt tranche as a liability, the bank reduces the explicit cost of its safe assets. The complementarity between the public and private liquidity leads to a multiplier effect at the aggregate level. If the cost of holding the safe asset goes down, then the bank not only holds more of the safe asset and the risky collateral, but also more safe asset per unit of the risky collateral. As a result, the liquid debt tranche increases, the balance sheet expands and total leverage is higher. This predicts pro-cyclical leverage which is also documented in Adrian and Shin (2014) for the financial intermediation sector of the economy (in particular shadow banks). Comparative statics of the model also has cross-sectional implications for monetary policy. For example, it predicts that when monetary policy tightens, that is, when the cost of safe assets increases, banks with loans that are more subject to adverse selections (eg., banks with a larger fraction of subprime mortgages) would shrink their balance sheet further and decrease their leverage more. This result is also consistent with the bank lending channel of monetary transmission in Kashyap, J.