government as borrower of first resort - london business.pdf

Government as Borrower of First Resort Gilles Chemla and Christopher A. Hennessy∗ June 2014 Abstract We examine optimal supply of safe government bonds accounting for their effect on corporate debt markets. Government bonds are shown to influence leverage under asymmetric information regarding corporate cash flows and safe asset scarcity. Corporations have incentives to issue junk debt in response to safe asset scarcity since uninformed investors then migrate to junk debt markets. Uninformed demand stimulates informed speculation which drives junk debt prices closer to fundamentals, encouraging pooling at high leverage. Acting as borrower of first resort, the government can issue safe bonds which siphon off uninformed demand for risky corporate debt and reduce socially wasteful informed speculation. Thus, government bonds either eliminate pooling at high leverage or improve risk sharing in such equilibria. An optimal supply of government bonds is increasing in both marginal Q and the intrinsic demand for safe assets. ∗Chemla is with Imperial College Business School, DRM/CNRS, and CEPR. Hennessy is with London Business School, CEPR and ECGI. In recent years the set of safe stores of value has contracted. A number of factors are responsible. The credit crisis of 2007/8 revealed the exposure of senior tranches of securitizations to correlated defaults. The Eurozone crisis called into question the safety of some sovereign debts. Finally, fiscal weakness undermined confidence in deposit insurance in some jurisdictions. At the same time, it has been argued, these crises stimulated investor demand for safe stores of value in a flight-to-quality. The p