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.