NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Collective Risk Management in a Flight to Quality Episode

Ricardo J. Caballero, Arvind Krishnamurthy

NBER Working Paper No. 12896
Issued in February 2007
NBER Program(s):   CF   EFG   IFM   ME

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.

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Document Object Identifier (DOI): 10.3386/w12896

Published: Ricardo J. Caballero & Arvind Krishnamurthy, 2008. "Collective Risk Management in a Flight to Quality Episode," Journal of Finance, American Finance Association, vol. 63(5), pages 2195-2230, October.

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