Financial System Risk and Flight to Quality

39 Pages Posted: 30 Nov 2005

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: November 21, 2005

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.

Keywords: Locked collateral, flight to quality, insurance, risk premia, financial intermediaries, 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, Financial System Risk and Flight to Quality (November 21, 2005). MIT Department of Economics Working Paper No. 05-31, Available at SSRN: https://ssrn.com/abstract=861484 or http://dx.doi.org/10.2139/ssrn.861484

Ricardo J. Caballero (Contact Author)

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Arvind Krishnamurthy

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