Savings Gluts and Financial Fragility∗

We investigate the effects of an increase in liquidity (a “savings glut”) on the incentives to originate high quality assets, and on the fragility of the financial sector. Originators incur private costs when originating high quality assets. Assets are subsequently distributed in two markets: A private market where informed intermediaries operate, and an exchange where uninformed investors trade. Uninformed investors pay the same price irrespective of the quality of the assets, which discourages good origination. Informed investors identify and pick the best assets by offering a premium over the uninformed price, which encourages originators to supply good assets. We show that there is a positive origination effect of an increase in savings of uninformed investors when the overall level of savings is low, but the opposite is true when liquidity is abundant, so that an increase in savings has a non-monotone effect on origination incentives. Leverage increases monotonically with savings and is highest precisely when incentives for good asset origination are at their lowest. Thus plentiful liquidity leads to fragile balance sheets: On the asset side non-performing assets accumulate and on the liability side more of those assets are funded with debt. We relate our findings to some of the stylized facts observed in financial markets in the lead up to the Great Recession. ∗We thank Hyun Shin and Chris Sims for insightful comments on an earlier version of the paper. We are grateful to Tobias Adrian and Tomasz Piskorski for the data they have provided to construct Figures 2 and 3. “Large quantities of liquid capital sloshing around the world should raise the possibility that they will overflow the container.” Robert M. Solow page vii in Foreword of Manias, Panics, and Crashes: A History of Financial Crises by Charles P. Kindleberger and Robert Aliber (2005)