Achieving safety: Personal, private, and public provision

Abstract

We study how a primary need for minimum safety affects investment choices. In addition to risky projects, agents may choose to invest in personal assets they can control. Investing in personal assets serves as self-insurance, as they ensure a higher minimum return but offer a lower expected return than the risky project offers. In autarky, investors ensure a minimum return by personal assets, besides investing in the risky project. Private intermediaries and a safe rate arise endogenously to limit inefficient self-insurance, with self-insured investors holding bank equity to safeguard private safe debt. The endogenous conflict over interim risk choices is resolved by demandable debt, forcing early liquidation in states in which the ability of banks to repay debt holders remains uncertain. Our work highlights the unintended consequences of public provision of safety for private provision of safety and aggregate investment, demonstrating that these effects depend critically on whether public provision takes the form of public debt or deposit insurance.