Saving Gluts, Lending Booms, Minsky moments

Abstract:

We investigate the effects of an increase of the savings rate on the incentives to originate high quality assets and on financial fragility.
Originators incur private costs when originating high quality assets. Assets are subsequently distributed in two markets by the financial sector: A private market where informed capital cream skims the best assets and a market that absorbs the pool of uninformed capital, an uninformed exchange. Informed capital matters because it provides incentives for good origination. Liquidity matters because it determines prices in the uninformed exchange. Two factors determine asset quality: the level of informed capital and the price spread between the private market and the uninformed exchange. If the level of informed capital is fixed an increase in the savings rate increases prices in the exchange and a narrowing of the spread which results in a deterioration of origination incentives. When the amount of informed capital is endogenously determined we show that in general origination incentives are non monotone in the savings rate. We show that when informed agents are able to take on leverage, leverage and the leverage ratio are increasing in the savings rate. The combination of asset deterioration and more leverage increases financial fragility.