Uncertainty Aversion and Systemic Risk

Journal of Political Economy 2019 127:3, 1118-1155

43 Pages Posted: 8 Nov 2014 Last revised: 9 Jul 2021

See all articles by David L. Dicks

David L. Dicks

Baylor University - Department of Finance, Insurance & Real Estate

Paolo Fulghieri

University of North Carolina Kenan-Flagler Business School; European Corporate Governance Institute (ECGI)

Multiple version iconThere are 2 versions of this paper

Date Written: June 2019

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, Systemic Risk, Financial Crises, Bank Runs

JEL Classification: D81, G01, G21, G28

Suggested Citation

Dicks, David L. and Fulghieri, Paolo, Uncertainty Aversion and Systemic Risk (June 2019). Journal of Political Economy 2019 127:3, 1118-1155 , Available at SSRN: https://ssrn.com/abstract=2519831 or http://dx.doi.org/10.2139/ssrn.2519831

David L. Dicks (Contact Author)

Baylor University - Department of Finance, Insurance & Real Estate ( email )

P.O. Box 98004
Waco, TX 76798-8004
United States

Paolo Fulghieri

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

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