Flight to Quality and Collective Risk Management / Ricardo J. Caballero, Arvind Krishnamurthy.

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Caballero, Ricardo J

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Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w12136.Publication details: Cambridge, Mass. National Bureau of Economic Research 2006.Description: 1 online resource: illustrations (black and white)Subject(s):

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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' 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' 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.

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Previous	nber w12133 A Political Economy Theory of the Soft Budget Constraint /	nber w12134 The Thick Market Effect on Housing Markets Transactions /	nber w12135 Political Risk Versus Market Risk in Social Security /	nber w12136 Flight to Quality and Collective Risk Management /	nber w12137 How Occupied France Financed Its Own Exploitation in World War II /	nber w12138 Bubbles and Busts: The 1990s in the Mirror of the 1920s /	nber w12139 The Homecoming of American College Women: The Reversal of the College Gender Gap /	Next

April 2006.

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' 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' 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.