Safety Transformation and the Structure of the Financial System |
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| Authors: | WILLIAM DIAMOND |
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| Institution: | 1. William Diamond is with the Wharton School of the University of Pennsylvania. I thank my advisors David Scharfstein, Sam Hanson, Jeremy Stein, and Adi Sunderam for their outstanding guidance and support. I also thank the Editor Philip Bond, two anonymous referees, and discussants Tetiana Davydiuk, John Kuong, and Giorgia Piacentino for very constructive comments as well as Nikhil Agarwal, Jules van Binsbergen, Douglas Diamond, Emmanuel Farhi, Itay Goldstein, Ye Li, Yueran Ma, Nikolai Roussanov, Alp Simsek, Argyris Tsiaras, Jessica Wachter, and John Zhu for helpful discussions and feedback. I have no conflicts of interest to disclose as identified in The Journal of Finance disclosure 2. policy. |
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| 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. |
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