Flight to Quality and Collective Risk Management

Ricardo J Caballero () and Arvind Krishnamurthy

No 12136, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We present a model of flight to quality episodes that emphasizes systemic risk and the Knightian uncertainty surrounding these episodes. Agents make risk management decisions with incomplete knowledge. They understand their own shocks, but are uncertain of how correlated their shocks are with systemwide shocks. Aversion to this uncertainty leads them to question whether their private risk management decisions are robust to aggregate events, generating conservatism and excessive demand for safety. We show that agents%u2019 actions lock-up the capital of the financial system in a manner that is wasteful in the aggregate and can trigger and amplify a financial accelerator. The scenario that the collective of conservative agents are guarding against is impossible, and known to be so even given agents%u2019 incomplete knowledge. A lender of last resort, even if less knowledgeable than private agents about individual shocks, does not suffer from this collective bias and finds that pledging intervention in extreme events is valuable. The benefit of such intervention exceeds its direct value because it unlocks private capital markets.

JEL-codes: E30 E44 E5 F34 G (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-bec, nep-cba, nep-fmk and nep-mac
Date: 2006-04
Note: CF EFG IFM ME
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