TY  - JOUR
AU  - Caballero,Ricardo J.
AU  - Krishnamurthy,Arvind
TI  - Flight to Quality and Collective Risk Management
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 12136
PY  - 2006
Y2  - April 2006
UR  - http://www.nber.org/papers/w12136
L1  - http://www.nber.org/papers/w12136.pdf
N1  - Author contact info:
Ricardo J. Caballero
MIT
Department of Economics
Room E52-373a
Cambridge, MA 02142-1347
Tel: 617/253-0489
Fax: 617/253-6915
E-Mail: caball@mit.edu

Arvind Krishnamurthy
Kellogg School of Management
Northwestern University
2001 Sheridan Road
Evanston, IL 60208
Tel: 847/491-2671
Fax: 847/491-5719
E-Mail: a-krishnamurthy@northwestern.edu
AB  - 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.
ER  -