Flight to Quality and Collective Risk Management

33 Pages Posted: 23 Mar 2006

See all articles by Ricardo J. Caballero

Ricardo J. Caballero

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Arvind Krishnamurthy

Northwestern University - Kellogg School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: March 15, 2006

Abstract

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 system-wide 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.

Keywords: Locked collateral, flight to quality, insurance, safe and risky claims, financial intermediaries, collective bias, lender of last resort, private sector multiplier, collateral shocks, robust control

JEL Classification: E30, E44, E5, F34, G1, G21, G22, G28

Suggested Citation

Caballero, Ricardo J. and Krishnamurthy, Arvind, Flight to Quality and Collective Risk Management (March 15, 2006). MIT Department of Economics Working Paper No. 06-07, Available at SSRN: https://ssrn.com/abstract=891856 or http://dx.doi.org/10.2139/ssrn.891856

Ricardo J. Caballero (Contact Author)

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Arvind Krishnamurthy

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