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Financial System Risk and Flight to Quality

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  • Ricardo Caballero
  • Arvind Krishnamurthy

Abstract

We present a model of flight to quality episodes that emphasizes financial system risk and the Knightian uncertainty surrounding these episodes. In the model, agents are uncertain about the probability distribution of shocks in markets different from theirs, treating such uncertainty as Knightian. Aversion to this uncertainty generates demand for safe financial claims. It also leads agents to require financial intermediaries to lock-up capital to cover their own markets' shocks in a manner that is robust to uncertainty over other markets. These actions are wasteful in the aggregate and can trigger a financial accelerator. A lender of last resort can unlock private capital markets to stabilize the economy during these episodes by committing to intervene should conditions worsen.

Suggested Citation

  • Ricardo Caballero & Arvind Krishnamurthy, 2005. "Financial System Risk and Flight to Quality," NBER Working Papers 11834, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:11834
    Note: CF DAE EFG IFM ME
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    Cited by:

    1. Vasco Cúrdia, 2005. "Monetary Policy under Sudden Stops," International Finance 0510025, University Library of Munich, Germany, revised 19 Dec 2005.
    2. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2006. "Bubbles and capital flow volatility: Causes and risk management," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 35-53, January.
    3. Shahzad, Syed Jawad Hussain & Nor, Safwan Mohd & Kumar, Ronald Ravinesh & Mensi, Walid, 2017. "Interdependence and contagion among industry-level US credit markets: An application of wavelet and VMD based copula approaches," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 466(C), pages 310-324.
    4. Beer, Francisca M. & Wellman, Joseph D., 2021. "Implication of stigmatization on investors financial risk tolerance: The case of gay men," Journal of Behavioral and Experimental Finance, Elsevier, vol. 31(C).
    5. Roberto Robatto, 2015. "Financial Crises and Systemic Bank Runs in a Dynamic Model of Banking," 2015 Meeting Papers 483, Society for Economic Dynamics.
    6. Leon, Jorge, 2010. "International Portfolios and the U.S. Current Account," MPRA Paper 45281, University Library of Munich, Germany.
    7. Coudert, Virginie & Gex, Mathieu, 2010. "Contagion inside the credit default swaps market: The case of the GM and Ford crisis in 2005," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 20(2), pages 109-134, April.

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    More about this item

    JEL classification:

    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • G1 - Financial Economics - - General Financial Markets

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