European Central Bank working paper links private safe-asset creation to excessive securitisation and proposes risk-retention as a corrective tool

The European Central Bank published Working Paper No 3044 by Madalen Castells-Jauregui on the private production of safe assets and related financial-stability implications, noting the analysis reflects the author’s views. The paper models financial intermediaries issuing “safe” debt backed by (i) their own loans and (ii) diversified loan pools obtained via securitisation, and finds that when safe assets are scarce, intermediaries increase diversification to expand safe-asset supply but weaken hidden screening incentives, reducing loan quality and potentially making private safe-asset supply backward-bending. In incomplete markets, intermediaries are shown to free-ride on others’ screening efforts because individual effort affects the ability of the system to generate safe payoffs through diversification, but this externality is not internalised in decentralised decisions. Against this benchmark, the paper argues that loan risk-retention requirements can raise “skin-in-the-game” and curb excessive securitisation, and suggests the retention rate should decrease as the safety premium rises; it also finds capital regulation ineffective in this setting. Public provision of safe assets (for example through government bonds) can mitigate scarcity and improve screening incentives but cannot fully resolve the inefficiency, and its impact on total private safe-debt issuance is ambiguous due to offsetting crowding-out of diversification and crowding-in of screening.