In a rare bipartisan moment of the 2016 election season, a group of US Senators introduced a bill late last month that would let municipal debt count among “High Quality Liquid Assets” (HQLA), the buffers banks must hold against liquidity shocks since the last financial crisis. The key argument for the bill cited in the news media was not about bank liquidity, but rather about the need to preserve market access for states, cities, and counties. Anointed as HQLA, municipal debt would gain preferred access to a special group of buyers, the country’s biggest financial institutions. Foreign governments made a similar argument just a few years earlier, when they lobbied US regulators for exemptions from the proprietary trading ban of the Volcker Rule, so as to preserve liquidity in their debt markets.1 In the late 1990s and early 2000s, the desire to preserve liquidity in yet another vital market—overnight repurchase agreements (repos)—animated the push for bankruptcy safe harbors, which put repos backed by an ever-widening range of collateral ahead of other claims, and effectively beyond the reach of bankruptcy law. The repo market boomed, until it collapsed in 2007–08.
These seemingly disconnected episodes tie into a debate in the economic literature and policy circles about safe assets, or financial contracts that market participants treat as if they were risk-free. This debate has broad implications for theories about crises and contagion, the role of government intervention in crisis, financial reform, and financial stability regulation.
While we take no position on the merits of the HQLA bill or the Volcker Rule exemption, we highlight initiatives such as these in our article, Inside Safe Assets (forthcoming in the Yale Journal on Regulation), to illustrate the essential role of legal and political intervention in creating entire classes of apparently safe and liquid debt at the heart of multi-trillion dollar financial markets.
“Safe assets” is a catch-all term that has at various times included government, bank, and AAA-rated corporate debt, asset-backed securities, commercial paper and repos, among others. Some of these markets lost value overnight during the global financial crisis that began in 2007, and soon after, during the euro area crisis. Panic selling, firm failures, and public rescues accompanied both episodes. The Federal Reserve became the largest holder of US commercial paper; the European Central Bank stepped in to buy government bonds.
The crises confirmed the obvious: There is no such thing as a risk-free financial contract. They also raised the academic and policy profile of safe assets. The term “safe assets” had appeared sporadically in scholarly and policy writings for decades, often as a shorthand for modeling assumptions. However, since 2007, this term has come to denote a vital market phenomenon and a major policy challenge, and has featured prominently in official speeches and Congressional testimony. In July of 2016, Federal Reserve Board Governor Daniel K. Tarullo highlighted risks to financial stability from some safe assets, alongside concerns about persistent market demand outstripping the limited supply of “genuinely safe assets.” Others have invoked safe assets to explain financial sector growth, shadow banking, financial crises, and prolonged economic stagnation. In a major report, the International Monetary Fund (IMF) estimated the aggregate value of safe assets at more than $114 trillion worldwide in 2011.2 By comparison, the total US economic output for 2011 was $15.5 trillion.
The economic literature on safe assets has focused on imbalances in safe asset supply and demand and their implications for financial stability and growth. Some of it speaks of safe assets in terms of poorly understood natural forces or essential particles newly detected in a supercollider. Law is mostly absent in this account, except as an occasional source of distortion.
We start from the obvious proposition that safe assets are not to be found in nature; they exist in economic theory and market practice. We then depart from the literature to ask what institutional design elements might make a financial contract “safe enough,” and what—or who—makes it possible for market participants to ignore the risks, and on what conditions. From this perspective, safe assets look a lot like legal fictions, a familiar device that inserts an assumption known to be false in a chain of reasoning, so as to solve a particular doctrinal problem.
Precisely because there are no risk-free contracts, the law can conjure and maintain safe asset fictions, and place them at the foundation of institutions and markets. It therefore makes no sense to ask whether mortgage-backed securities, bank deposits, or Italian government debt are “entirely risk-free.” Their safety, such as it is, ultimately rests on state capacity to regulate, collect taxes, and issue money, and state willingness to deploy these powers in specific ways for the sake of particular constituents and markets. Instead of asking whether a contract is risk-free, it pays to ask what purpose and whose interests might be served by a societal commitment to act as if it were risk-free, and to consider the cost of such a commitment. Whether anyone who acts “as if” believes in the inherent safety of safe assets, or chooses to ignore risks believing that she would be made whole, is also a second-order concern. State intervention can justify her actions either way.3 Safe assets thus emerge from a mix of public and private ordering, unavoidably distributive and fraught with distortions.
Our article makes four contributions. First, we describe the legal architecture of safe assets, or where safe assets get their safety—an institutional question on which the economic literature is silent. Second, we offer a unified analytical framework that links the safe asset debate with postcrisis legal critiques of money, banking, structured finance, and bankruptcy. Third, we highlight sources of instability and distortion in the legal architecture, and the political commitments it entails. Fourth, we offer preliminary prescriptions to correct some of these failings.
After a brief overview of the debate about safe assets in the literature, we map out three categories of legal intervention:
- Making assets safer (more likely to pay off in full and on time), which entails a form of financial engineering, often achieved through a mix of priorities, exemptions, and prudential mandates.
- Labeling assets as safe, for example, zero-risk, fixed-value, or AAA, which encourages market participants to buy them.
- Guarantees, which can turn private contracts into public commitments. These may be extended ex ante or ex post, as bailouts.
Using this three-part framework, we explore vulnerabilities in the legal architecture of safe assets and links to financial stability. We part ways with the prevailing explanations of financial instability in concepts such as shadow banking (unregulated intermediation), which focus on short-term runnable liabilities, and highlight the boundary between the lit (regulated) and the shadowy (unregulated) in finance. We are equally interested in the assets securing runnable liabilities and the liabilities themselves. We highlight pervasive misalignment between assets made or guaranteed safe, and those merely labeled and widely used as if they were risk free. An asset that is labeled safe, but not made safe enough for the way in which it is used, can lose value abruptly, and trigger runs and contagion, followed by pressure for state or even supranational guarantees. Implicit guarantees fill the gap between safe asset facts and safe asset fictions.
Governments and private actors can exploit misalignment over time. Officials can use labels to direct financing for their policy priorities, betting that they would not have to pay out on the implicit guarantees during their time in office. Market participants can boost their returns by issuing or buying risky assets labeled safe, counting on the state to absorb losses when risk materializes. Legal interventions in safe asset markets distribute resources on a large scale and nurture powerful constituencies for risk-free treatment. Labels and technical jargon obscure the vested interests and distributional effects.
Misalignment is cyclical. It is easy to miss when credit is abundant, when “relatively safe” looks indistinguishable from “absolutely safe,” and different assets are used interchangeably as if they were risk-free. Risk-free labels look like self-evident descriptions, while making contracts safer for bad times seems unnecessary. A crisis makes risk apparent and forces realignment. Labels either fail or are validated with government guarantees.
We end with preliminary policy prescriptions. We argue that legal intervention should promote dynamic monitoring and alignment among risk attributes, safety labels, and the public safety net throughout the credit cycle. Periodic stress tests applied to contracts and markets, rather than institutions, can reveal gaps in oversight and risks to financial stability, help trace crisis transmission channels, gauge the contingent liability for the public from a sudden loss of safety, and encourage timely intervention to reduce latent risks.
We also argue that regulatory risk-free labels are especially problematic as a form of intervention, and should be discouraged. As a first step, we argue for presumptively treating labels as express guarantees by the labeling government. Overall, our framework for analyzing safe assets suggests that macroprudential policy can accomplish a lot with existing regulatory tools, and may not require a new space-age toolkit.
Safe assets have been described as the cornerstone of the global financial system, the essential ingredient of finance in danger of getting “squelched” by overzealous regulation—and at the opposite extreme, as a dangerous falsehood, a mutant meme whose replication must be stopped. Legal fictions have elicited similar rhetoric for centuries: Jeremy Bentham memorably described them as “a wart, which … deforms the face of justice,” or, worse, “a syphilis,” which makes the law rot from within. Courts, legislatures, and administrators today show no sign of abandoning fictions. So, too, with safe assets. In a world where no contract is risk-free, they meet functional needs of market participants and policymakers to act “as if.” The law is essential to constructing safe assets, and to managing the risks they pose for financial stability.
The full article is available here.
1. US Treasuries were already exempt under the Dodd-Frank Act. Foreign government debt gained a partial and qualified exemption in 2014.
2. The $114 trillion estimate is the sum of $74.4 trillion in potential safe assets held by wholesale investors in June 2011, and $40 trillion in customer bank deposits at the end of 2010 (fig. 3.4 and n.16). IMF staff analysis excludes deposits because (i) they reflect primarily household and nonfinancial firm holdings and (ii) present distinct financial stability concerns. We add back deposits because claims on banks figure prominently in other leading treatments of safe assets. For US economic output, see GDP (Current US$), World Bank (last visited March 12, 2015).
3. Our view of safe assets is close to what Brunnermeier and Haddad have described in a recent presentation as the “Safe Asset Tautology” view, in which “an asset is safe as long as it is perceived to be safe.” Markus Brunnermeier and Valentin Haddad, Safe Assets, Federal Reserve Bank of New York, October 17, 2014 (contrasting the “Safe Asset Tautology” with the “Good Friend Analogy,” in which safe assets are “safe across any horizon,” including in crisis). In our view, while some assets might pay off in full in more states of the world, all require a leap of faith to be used as if they were risk-free. While we concur with the authors’ assessment of bubble and bust risks inherent in the safe asset tautology, we are hard pressed to find safe assets outside the tautology.