Safety Transformation and the Structure of the Financial System

That is the job market paper from William Diamond, who is on the market this year from Harvard University.  I think of this paper as trying to explain some of the financial market puzzles about divergent asset returns, and the financial crisis, in one unified framework.  That is a tall order, but I think he actually makes some progress on creating a coherent story about segmented asset markets, ultimately driven by agency problems.  Here is the abstract:

This paper develops a model of how the financial system is organized to most effectively create safe assets and analyzes its implications for asset prices, capital structure, and macroeconomic policy.  In the model, financial intermediaries choose to invest in the lowest risk assets available in order to issue safe securities while minimizing their reliance on equity financing.  Although households and intermediaries can trade the same assets, in equilibrium all debt securities are owned by intermediaries since they are low risk, while riskier equities are owned by households.  The resulting market segmentation explains the low risk anomaly in equity markets and the credit spread puzzle in debt markets and determines the optimal leverage of the non-financial sector.  An increase in the demand for safe assets causes an expansion of the financial sector and extension of riskier credit to the non-financial sector- a subprime boom. Quantitative easing increases the supply of safe assets, leading to a compression of risk premia in debt markets, a deleveraging of the non-financial sector, and an increase in output when monetary policy is constrained.  In a quantitative calibration, the segmentation of debt and equity markets is considerably more severe when intermediaries are poorly capitalized.

His degree is in Business Economics, a program that combines the economics Ph.d with some features of the Harvard MBA.


Split infinitive

"Quantitative easing increases the supply of safe assets, . . . ." It does? Isn't "quantitative easing" the policy of the central bank purchasing government securities (to lower interest rates), which reduces the supply of safe assets. That's a reason for Professor Farmer's alternative proposal (government purchases of non-governmental assets): to avoid the reduction in the supply of safe assets when they are most in demand. I suppose the possibility of quantitative easing tomorrow increases the supply of safe assets today (since there's a built-in demand for them tomorrow if there's a financial crisis, it increases the supply/demand for them today). Is that what the author means?

Why isn't buying real productive assets "safe"? Ie, why isn't it safe for an individual to buy his home? If the price of a home falls by 50%, does the house shrink by 50%?

And I have seen absolutely no evidence that rents on 90% of rental properties have fallen in the last quarter century. And housing rents in even the effectively bombed out cities from globalization increase in relative price to the below cost prices of existing structures.

Clearly the debate is only about MZM.

Is MZM really a capital asset?

How can MZM be productive?

Fed policy has increased MZM by 40% since Obama took office.

But that was after increasing MZM by 90% while Bush was president, and triggering a financial crisis when the growth rate in MZM faltered in the second half of 2008.

But the velocity of MZM has generally fallen since 1980 indicating even pure "cash" is less liquid and thus increasingly risky. M1V is also much lower today than in 1980 making it less liquid and riskier.

From a 30 second read of the paper, I figured out Diamond’s model*: financial intermediaries (e.g., banks) like to bid up the prices of non-stock securities like debt, since apparently they are forbidden to invest in ‘risky’ stocks and they like leverage. But households are more risk adverse than banks, and they hold the majority of equity, 80% says this [ - "However, the total effective household ownership is closer to 80 percent when combined with indirect ownership in the form of mutual funds (20 percent), pension funds (16 percent), and insurance policy holdings (7 percent)"], so prices of stocks are mispriced, as a class, leading to the famous ‘equity premium puzzle’. With the above priors “everything makes sense”, which is akin to saying in a friction free world, there’s no friction. Move along, nothing to see here…

Bonus trivia: Diamond is a (in)famous last name in finance. There’s the Greek-Am Jamie Diamond who’s last name in Greek means ‘diamond’, and there’s the scandal-hit Robert Edward "Bob" Diamond, Jr. , More non-bank Diamond surnamed people here: and note the kickboxer Ramon "The Diamond" Dekkers (4 September 1969 – 27 February 2013).


* Diamond: “Because each non-financial firm sells its debt to an intermediary and its equity to a house-hold, debt and equity markets are segmented. Within each asset class, the same marginal investor owns all securities, and there is a unique market price of risk. However, all debt secu-rities are held by financial intermediaries, while all equities are held by households, so the price of risk is strictly greater in the debt market. This provides a rationale for the "credit spread puzzle" (Huang and Huang 2012) in debt markets which finds that credit spreads on corporate bonds are too large to easily reconcile with risk premia in equity markets. This also explains the "low risk anomaly" (Black Jensen Scholes 1972, Baker Bradley Taliaferro 2014) in equity markets, which finds that simple measures of risk (such as CAPM beta) are inconsistent with a high expected return on equities and low risk free rate. The model is able to explain the low risk anomaly because the risk free rate lies strictly below the rate implied by the pricing kernel in equity markets as a result of the demand for safe assets as in (Bansal Coleman 1996).”

I don't suppose soon-to-be-Dr. Diamond has any relatives in related areas of academic Economics?

Safety is really very important, I believe if there is no safety then it’s really hard to trust up anything. I will always be extremely careful with how I go about doing things because only through there it’s possible to gain rewards. I do it all very nicely with Forex trading in OctaFX broker where they have epic bonus which is up to 50% and is use able too, so that’s why I am able to trade so nicely and it’s something that brings rewards to me.

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