Arpit Gupta pushes back on my post about why safe assets matter. He invokes Jeffrey Friedman and Vladimar Kraus' argument that implies regulatory arbitrage created by the Basel reforms can explain the demand for safe assets. Here is Gupta:
If a bank decided to hold a AAA-rated sovereign bond, for instance, they typically had to hold zero excess capital to meet regulatory standards. However, if they held an equivalent amount of an unsecured private loan, they were required to hold substantially more capital in response. The net effect of these capital regulatory standards is that safe assets came to be valued not just for their economic riskless value — but also for how alter bank capital requirements. Banks that face fewer capital requirements can be more levered, risky, and potentially profitable than banks whose assets force them to raise substantial amounts of additional capital. This motive, arguably, is why banks around the world are eager to purchase safe assets — not because they are useful in conducting repo.
Gupta also makes some other points, but this is his main one. His point sounds reasonable, but I wonder how important this effect is explaining the overall trend. As I mentioned in my previous post, this shortage of safe assets can arguably be traced all the way back to the bursting of Japan's asset bubble. It is also influenced by the gap between the rapid economic growth in the emerging world and their own inability to produce safe assets. And then there is the demographic challenge: all the baby boomers in the rich world are shifting out of riskier assets into safer ones as they retire. Is Basel really more important than all these other factors?
P.S. Gupta also has an interesting post on whether deleveraging matters, which is timely once again given Richard Koo has a new paper pushing his balance sheet recession view. My view is that deleveraging can have dire consequences as described by Koo, but only if monetary policy is failing to do its job. Look no further than Sweden which has a lot of household debt, but managed to restore nominal incomes following the financial crisis and thus keep debt burdens manageable. Monetary policy was also not limited in the United States when it was tried during the Great Depression, a time of high debts too. If only balance sheet recession advocates would spend as much time gazing at the asset side of the household balance sheets as they do the liability side they might see the potential for monetary policy. Oh, and don't forget this Scott Sumner smackdown of the balance sheet recession view.
P.P.S. Matthew Yglesias does a better job than me summarizing why safe assets matter.