Uncertainty Aversion and Systemic Risk

Paolo Fulghieri and David Dicks

No 10510, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: We propose a new theory of systemic risk based on Knightian uncertainty (or "ambiguity"). We show that, due to uncertainty aversion, beliefs on future asset returns are endogenous, and bad news on one asset class induces investors to be more pessimistic about other asset classes as well. This means that idiosyncratic risk can create contagion and snowball into systemic risk. Furthermore, in a Diamond and Dybvig (1983) setting, we show that, surprisingly, uncertainty aversion causes investors to be less prone to run individual banks, but runs will be systemic. In addition, we show that bank runs are associated with stock market crashes and flight to quality. Finally, we argue that increasing uncertainty makes the financial system more fragile and more prone to crises. We conclude with implications for the current public policy debate on the management of financial crisis

Keywords: ambiguity aversion; Bank runs; Financial crises; Systemic risk (search for similar items in EconPapers)
JEL-codes: G01 G21 G28 (search for similar items in EconPapers)
Date: 2015-03
New Economics Papers: this item is included in nep-ban, nep-cfn, nep-rmg and nep-upt
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Citations: View citations in EconPapers (2)

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