Working Paper: NBER ID: w12136
Authors: Ricardo J. Caballero; Arvind Krishnamurthy
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 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.
Keywords: flight to quality; systemic risk; knightian uncertainty; lender of last resort
JEL Codes: E30; E44; E5; F34; G1; G22; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| agents' perceptions of risk (D80) | capital lockup (G34) |
| capital lockup (G34) | financial instability (F65) |
| lender of last resort intervention (E58) | unlock private capital markets (G24) |
| lender of last resort intervention (E58) | alleviates collective bias (J15) |
| lender of last resort intervention (E58) | efficient allocation of capital (G31) |