Collective Risk Management in a Flight to Quality Episode / Ricardo J. Caballero, Arvind Krishnamurthy.

Format:

Book

Author/Creator:

Caballero, Ricardo J.

Contributor:

National Bureau of Economic Research.

Krishnamurthy, Arvind.

Series:

Working Paper Series (National Bureau of Economic Research) no. w12896.

NBER working paper series no. w12896

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2007.

Summary:

We present a model of optimal intervention in a flight to quality episode. The reason for intervention stems from a collective bias in agents' expectations. Agents in the model make risk management decisions with incomplete knowledge. They understand their own shocks, but are uncertain of how correlated their shocks are with systemwide shocks, treating the latter uncertainty as Knightian. We show that when aggregate liquidity is low, an increase in uncertainty leads agents to a series of protective actions -- decreasing risk exposures, hoarding liquidity, locking-up capital -- that reflect a flight to quality. However, the conservative actions of agents leave the aggregate economy over-exposed to negative shocks. Each agent covers himself against his own worst-case scenario, but the scenario that the collective of agents are guarding against is impossible. 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 intervention unlocks private capital markets.

Notes:

Print version record

February 2007.