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Market-Based Solutions to Vital Economic Issues


Kenan Institute 2024 Grand Challenge: Business Resilience
Market-Based Solutions to Vital Economic Issues
Apr 3, 2019

Uncertainty Aversion and Systemic Risk


We propose a new theory of systemic risk based on Knightian uncertainty (“ambiguity”). Because of uncertainty aversion, bad news on one asset class worsens investors’ expectations on other asset classes, so that idiosyncratic risk creates contagion, snowballing into systemic risk. In a Diamond and Dybvig setting, uncertainty-averse investors are less prone to run individual banks, but runs can be systemic and are associated with stock market crashes and flight to quality. Finally, increasing uncertainty makes the financial system more fragile and more prone to crises. Implications for the current public policy debate on management of financial crisis are derived.

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