Board of Governors of the Federal Reserve System

November 09, 2020

The Stability of Safe Asset Production

Sara Almadani ¹, Michael Batty, Danielle Nemschoff, and Wayne Passmore*

A safe asset is a debt instrument that is expected to maintain its value over time, especially during adverse systemic events. Changes in the supply of safe assets can have a significant influence on short-term, risk-free interest rates. (Ferreira & Shousha, 2020) "When the scarcity of safe asset[s] is acute, the zero lower bound (ZLB) becomes binding and the safe asset market equilibrates via a reduction in output…" (Caballero, Farhi, & Gourinchas , 2016).

The supply of safe assets has been concentrated in a small number of advanced economies: Germany, France, the United Kingdom, but most prominently by the United States. Despite their growing public sector deficits in these countries, the supply has not kept pace with the global demand in the past decade. Some observers attribute the lack of supply to the deceleration in the growth rate of the advanced economies relative to the world's growth rate, as well as the rapid growth rate of high saving emerging economies in comparison with the advanced-economy public debt. (Caballero, Farhi, & Gourinchas, 2017)

One remarkable claim is the percentage of safe assets in the United States has remained very stable over time (see e.g. (Gorton, Lewellen, & Metrick, 2012) and (Gorton, 2017)). In particular, the fraction of safe assets to total assets in the economy has remained in a range between 30–35 percent during the past 7 decades. Here, we update the data on safe assets, as defined using the Financial Accounts of the United States (Z.1), and show that this claim is still true. We also update the components of safe assets and show that while the overall proportion has remained the same, there has been a significant shift in the components. For many years, the role of banks in the production of safe assets has been declining. But since the Great Financial Crisis (GFC), safe asset production has shifted back to depositories and away from shadow banking. Still, the declining contribution of banks remains notable.

The Stability of Safe Assets Hypothesis

Gorton, Lewellen, & Metrick (2012) uses information collected in the Federal Reserve's Financial Accounts of the United States for the years 1952 to 2010. Figure 1 below updates the analysis through 2020. The red area represents the safe assets issued by U.S. federal, state, and local governments as a share of total assets in the U.S. economy, the blue area represents safe assets issued by the financial sector, and the dotted line indicates the average proportion of safe assets over the years 1952 to 2020 (31.1 percent). The standard deviation of the safe asset share has been 2.3 percent, suggesting that the hypothesis of a relatively constant proportion of safe assets remain true.

Figure 1. The Safe Assets Share

Calculating the Share of Safe Assets

Safe assets consist of selected liabilities issued by the financial and government sectors of the U.S. economy.² Government liabilities are explicitly backed by the United States, and are viewed as the "safest" of safe assets. The financial liabilities we select are produced by the private sector and are deemed by investors as very safe (from credit risk). This clearly is a judgment call, and the judgments can vary across assets and across time. For example, the (time-varying) polices of governments and central banks are key to what assets are deemed to be safe (Gourinchas & Jeanne, 2012). However, as noted by Gorton and his co-authors, the privately produced safe asset component is substantial under a range of plausible assumptions.³

We follow the safe asset share calculation outlined in (Gorton, Lewellen, & Metrick, 2012), adapting it for subsequent changes to the Financial Accounts' categorization of financial instruments and economic sectors. For the numerator of total safe assets, these changes include a variety of technical updates that alter the series number attached to a given liability (marked with * in Appendix A), and adding and classifying liabilities of the financial and government sectors that were not separately identified when the work was first completed (marked with **).⁴ We calculate the denominator of the safe asset share by summing the asset holdings of all sectors of the Financial Accounts.⁵

The Rise and Fall[?] of Shadow Banking

Gorton and coauthors break safe financial liabilities into five main categories, as illustrated in Figure 2. Looking at the data from 1952 to 2010, bank deposits declined from approximately 80 percent to 25 percent for the years 1952-2008, followed by a slight increase from 2008 till 2010 to approximately 29 percent. The shortage of safe debt produced by depositories played a role in expanding the shadow banking system, which created USD-denominated debt securities that perceived by investors as being as safe as government liabilities. For example, from 1952 to 2008, the money-like debt and MBS/ABS debt both increased by around 16 percentage points (the share of money-like debt increased from 10 percent to 26 percent, and the share of MBS/ABS debt increased sharply from almost zero percent to 17 percent). Also, the share of corporate bonds increased from 2 percent to 14 percent and other liabilities share increased from 8 percent to 18 percent. As Gorton (2017) states, "The change corresponds to the rise of the shadow banking industry."

Our updated chart shows that the reversal of this trend that began in the aftermath of the GFC has continued over the past ten years, and by 2020 deposits stood at 35 percent of safe assets—a substantial move upwards. This increase is mirrored by decreases in the assets that are produced by the shadow banking system. In particular, the share of money-like debt and MBS/ABS debt fell to 22.7 percent and 15.4 percent respectively from 2008 to 2020. Corporate bonds and other liabilities also fell, though to a lesser degree, with declines to shares of 8.7 percent and 17.3 percent respectively.

Depositories rely on insured deposits. In contrast, the money-like debt and the MBS/ABS debt categories are dominated by the funding of mortgage-related activities using wholesale funds (often collateralized). The characteristics of non-bank funding of mortgages ("banking without deposits") is analyzed in (Jiang, Matvos, Piskorski, & Seru, 2020). One of their results suggests that a substantial proportion of banks take advantage of the deposit subsidy, which drives their capital structure choice. In particular, the banks' leverage ratios are likely pinned down by deposit subsidies and capital requirements. Banks borrow as much as they can subject to capital requirements because they have access to subsidized debt funding. Another result suggests the relative leverage available to the "shadow bank" funder of mortgages can be an important determinant of who funds the mortgage. Many observers have noted that shadow banks take advantage of relatively high capital requirements for safer mortgages in the banking industry.

Thus, we speculate that the decline in the safe asset share at depositories reflects the market investors' pre-GFC views of minimal risks in mortgage markets. Consistent with these views, the stability of insured deposits in banking as a funding source was little valued, and the capital requirements in banking for some mortgages were viewed as too high. After the GFC, the relative advantages of shadow banks diminished some as market-based funders reassessed the risks of banking activities. With shadow banks viewed as more risky, some the decline in the share of safe assets produced by depositories was reversed. The decline of the relative importance of depositories as a producer of safe assets over the past 70 years, however, still remains remarkable. This may in turn have implications for financial stability, as discussed in Gorton (2017).

Figure 2. The Components of Safe Financial Debt

Source: Base on authors' calculation using the Financial Accounts of the United States, and following the method presented in (Gorton, Lewellen, & Metrick, 2012).

Appendix A:

The tables below shows which Financial Accounts liabilities of the government and financial sectors are and are not classified as safe assets. “85” indicates that 85% of that liability is counted as a safe asset. “X” indicates that the liability is excluded from total assets because it represents an intergovernmental loan. Entries marked with “*” have changed series numbers in the Financial Accounts since the original work by (Gorton, Lewellen, & Metrick, 2012). Entries marked with “**” represent Financial Accounts liabilities that were not separately identified at that time.

Works Cited

Caballero, R. J., Farhi, E., & Gourinchas , P.-O. (2016). Safe Asset Scarcity and Aggregate Demand. American Economci Review: Papers & Proceedings, 513- 518.

Caballero, R. J., Farhi, E., & Gourinchas, P.-O. (2017). The Safe Assets Shortage Conundrum. Journal of Economic Perspectives, 29–46.

Eden, M., & Kay, B. S. (2019). Safe Assets as Commodity Money. Journal of Money, Credit and Banking, 1651-89.

Ferreira, T., & Shousha, S. (2020). Scarcity of Safe Assets and Global Neutral Interest Rates. International Finance Discussion Papers.

Gorton, G. (2017). The History and Economics of Safe Assets. Annual Review of Economics, 547-586.

Gorton, G., Lewellen, S., & Metrick, A. (2012). The Safe-Asset Share. American Economic Review: Papers & Proceeings, 101-106.

Jiang, E., Matvos, G., Piskorski, T., & Seru, A. (2020). Banking Without Deposits: Evidence from Shadow Bank Call Reports. National Bureau of Economic Research No. 26903.