Flight to Quality and Collective Risk Management
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.
We are grateful to Marios Angeletos, Olivier Blanchard, Phil Bond, Jon Faust, Xavier Gabaix, Jordi Gali, Michael Golosov, William Hawkins, Burton Hollifield, Bengt Holmstrom, Dimitri Vayanos, Ivan Werning and seminar participants at Columbia, DePaul, Imperial College, LBS, Northwestern, MIT, Wharton, NY Fed Liquidity Conference, NBER MIDM Conference, UBC Summer Conference, Bank of England, and the Central Bank of Chile for their comments. David Lucca and Alp Simsek provided excellent research assistance. Caballero thanks the NSF for financial support. This paper covers the same substantive issues as (and hence replaces) "Financial System Risk and Flight to Quality," NBER WP #11996 (2005) with a simpler but more abstract model. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.
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.