Flight to Quality and Collective Risk Management / 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. w12136.

NBER working paper series no. w12136

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2006.

Summary:

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.

Notes:

Print version record

April 2006.