TY  - JOUR
AU  - Caballero,Ricardo J.
AU  - Krishnamurthy,Arvind
TI  - Collective Risk Management in a Flight to Quality Episode
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 12896
PY  - 2007
Y2  - February 2007
UR  - http://www.nber.org/papers/w12896
L1  - http://www.nber.org/papers/w12896.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 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.
ER  -