Safety Transformation and the Structure of the Financial System

60 Pages Posted: 9 Aug 2018 Last revised: 4 Jan 2021

See all articles by William Diamond

William Diamond

University of Pennsylvania - Finance Department

Date Written: April 6, 2019

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 non-financial firms’ debt. Non-financial 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.

Keywords: financial intermediation, safe assets, quantitative easing, intermediary asset pricing, capital structure

Suggested Citation

Diamond, William, Safety Transformation and the Structure of the Financial System (April 6, 2019). Available at SSRN: https://ssrn.com/abstract=3219332 or http://dx.doi.org/10.2139/ssrn.3219332

William Diamond (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

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