Working Paper: CEPR ID: DP10510
Authors: David L. Dicks; Paolo Fulghieri
Abstract: We propose a new theory of systemic risk based on Knightian uncertainty (or "ambiguity"). We show that, due to uncertainty aversion, beliefs on future asset returns are endogenous, and bad news on one asset class induces investors to be more pessimistic about other asset classes as well. This means that idiosyncratic risk can create contagion and snowball into systemic risk. Furthermore, in a Diamond and Dybvig (1983) setting, we show that, surprisingly, uncertainty aversion causes investors to be less prone to run individual banks, but runs will be systemic. In addition, we show that bank runs are associated with stock market crashes and flight to quality. Finally, we argue that increasing uncertainty makes the financial system more fragile and more prone to crises. We conclude with implications for the current public policy debate on the management of financial crisis
Keywords: ambiguity aversion; bank runs; financial crises; systemic risk
JEL Codes: G01; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Uncertainty aversion (D81) | Endogenous beliefs about asset returns (G40) |
| Negative news in one asset class (G19) | Pessimism about others (contagion effect) (D91) |
| Uncertainty aversion (D81) | Systemic runs (E44) |
| Uncertainty aversion (D81) | Financial fragility (F65) |
| Increased uncertainty (D89) | Higher propensity for crises (H12) |
| Bank runs (E44) | Stock market crashes (G01) |
| Uncertainty aversion (D81) | Likelihood of individual bank runs (E44) |