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Collective Risk Management in a Flight to Quality Episode

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Author Info
Ricardo J. Caballero
Arvind Krishnamurthy

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Abstract

We present a model of optimal intervention in a flight to quality episode. The reason for intervention stems from a collective bias in agents' expectations. Agents in the model make risk management decisions with incomplete knowledge. They understand their own shocks, but are uncertain of how correlated their shocks are with systemwide shocks, treating the latter uncertainty as Knightian. We show that when aggregate liquidity is low, an increase in uncertainty leads agents to a series of protective actions -- decreasing risk exposures, hoarding liquidity, locking-up capital -- that reflect a flight to quality. However, the conservative actions of agents leave the aggregate economy over-exposed to negative shocks. Each agent covers himself against his own worst-case scenario, but the scenario that the collective of agents are guarding against is impossible. 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 intervention unlocks private capital markets.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12896.

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Date of creation: Feb 2007
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Handle: RePEc:nbr:nberwo:12896

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Find related papers by 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
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages
G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies
G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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Cited by:
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  1. Markus K. Brunnermeier, 2008. "Deciphering the Liquidity and Credit Crunch 2007-08," NBER Working Papers 14612, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. Chollete, Lorán, 2009. "The Propagation of Financial Extremes," Discussion Papers 2008/25, Department of Finance and Management Science, Norwegian School of Economics and Business Administration. [Downloadable!]
  3. Angelo Ranaldo & Paul Söderlind, 2007. "Safe Haven Currencies," University of St. Gallen Department of Economics working paper series 2007 2007-22, Department of Economics, University of St. Gallen. [Downloadable!]
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  4. Charlotte Christiansen & Angelo Ranaldo, 2007. "Extreme Coexceedances in New EU Member States’ Stock Markets," CREATES Research Papers 2007-34, School of Economics and Management, University of Aarhus. [Downloadable!]
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  5. Zhang, Zhipeng, 2009. "Who Pulls the Plug? Theory and Evidence on Corporate Bankruptcy Decisions," MPRA Paper 17676, University Library of Munich, Germany, revised 05 Oct 2009. [Downloadable!]
  6. Acharya, Viral V. & Gale, Douglas M & Yorulmazer, Tanju, 2009. "Rollover Risk and Market Freezes," CEPR Discussion Papers 7122, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  7. Martin Ellison & Thomas J. Sargent, 2009. "A defence of the FOMC," Economics Series Working Papers 457, University of Oxford, Department of Economics. [Downloadable!]
  8. Zhang, Zhipeng, 2009. "Recovery Rates and Macroeconomic Conditions: The Role of Loan Covenants," MPRA Paper 17521, University Library of Munich, Germany. [Downloadable!]
  9. Chollete, Lorán, 2008. "The Propagation of Financial Extremes: An Application to Subprime Market Spillovers," Discussion Papers 2008/2, Department of Finance and Management Science, Norwegian School of Economics and Business Administration. [Downloadable!]
  10. Ricardo J. Caballero & Alp Simsek, 2009. "Complexity and Financial Panics," NBER Working Papers 14997, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  11. Joshua Aizenman, 2009. "Financial Crisis and the Paradox of Under- and Over-Regulation," NBER Working Papers 15018, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  12. Ricardo J. Caballero, 2006. "On the Macroeconomics of Asset Shortages," NBER Working Papers 12753, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  13. Andrei Shleifer & Robert W. Vishny, 2009. "Unstable Banking," NBER Working Papers 14943, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  14. Arvind Krishnamurthy, 2009. "Amplification Mechanisms in Liquidity Crises," NBER Working Papers 15040, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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