Flight to quality
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A flight-to-quality, or flight-to-safety, is a financial market phenomenon occurring when investors sell what they perceive to be higher-
risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...
investments and purchase safer investments, such as
gold Gold is a chemical element with the Symbol (chemistry), symbol Au (from la, aurum) and atomic number 79. This makes it one of the higher atomic number elements that occur naturally. It is a Brightness, bright, slightly orange-yellow, dense, s ...
and other precious metals. This is considered a sign of
fear Fear is an intensely unpleasant emotion in response to perception, perceiving or recognizing a danger or threat. Fear causes physiological changes that may produce behavioral reactions such as mounting an aggressive response or fleeing the thr ...
in the marketplace, as investors seek less risk in exchange for lower profits. Flight-to-quality is usually accompanied by an increase in demand for assets that are government-backed and a decline in demand for assets backed by private agents.


Definition

More broadly, flight-to-quality refers to a sudden shift in investment behaviors in a period of financial turmoil whereby investors seek to sell assets perceived as risky and instead purchase safe assets. A defining feature of flight-to-quality is insufficient risk-taking by investors. While excessive risk-taking can be a source of financial turmoil, insufficient risk-taking can severely disrupt credit and other financial markets during a financial turmoil. Such a portfolio shift further exposes the financial sector to negative shocks. An increase in leverage and credit spread on all but the safest and most liquid assets may incur a sudden dry up in risky asset markets, which may lead to real effects on the economy. A phenomenon that occurs with flight-to-quality is flight-to-liquidity. A flight-to-liquidity refers to an abrupt shift in large capital flows towards more liquid assets. One reason why the two appear together is that in most cases risky assets are also less liquid. Assets that are subject to the flight to quality pattern are also subject to flight to liquidity. For example, a U.S. Treasury bond is less risky and more liquid than a corporate bond. Thus, most theoretical studies that attempt to explain underlying mechanisms take both flight-to-quality and flight-to-liquidity into account.


Mechanism

Flight-to-quality episodes are triggered by unusual and unexpected events. These events are rare but the list is longer than a few. The
Penn Central Railroad The Penn Central Transportation Company, commonly abbreviated to Penn Central, was an American class I railroad In the United States, Rail transport, railroad carriers are designated as Class I, II, or III, according to annual revenue criteri ...
’s default in 1970, a sudden stock market crash referred to as
Black Monday Black Monday refers to specific Mondays when undesirable or turbulent events have occurred. It has been used to designate massacres, military battles, and stock market crashes. Historic events *1209, Dublin – when a group of 500 recently arriv ...
, the Russian debt default and collapse of
Long Term Capital Management Long-Term Capital Management L.P. (LTCM) was a Leverage (finance), highly-leveraged hedge fund. In 1998, it received a $3.6 billion bailout from a group of 14 banks, in a deal brokered and put together by the Federal Reserve Bank of New York. LT ...
in 1998, the 9/11 attack in 2001, and the
subprime mortgage crisis The United States subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010 that contributed to the Financial crisis of 2007–2008, 2007–2008 global financial crisis. It was triggered by a large decline ...
in 2008, were all unusual and unexpected events that caught market participants by surprise. The initial effects of these events were a fall in asset prices and aggregate quantity of
liquidity Liquidity is a concept in economics involving the convertibility of assets and obligations. It can include: * Market liquidity, the ease with which an asset can be sold * Accounting liquidity, the ability to meet cash obligations when due * Liqui ...
in
financial market A financial market is a market (economics), market in which people trade financial Security (finance), securities and derivative (finance), derivatives at low transaction costs. Some of the securities include stocks and Bond (finance), bonds, ...
which deteriorated balance sheets of both borrowers and investors. Worsening of initial impacts developed into a flight-to-quality pattern, as the unusual and unexpected features of the events made market participants more risk and uncertainty averse, incurring more aggressive reactions compared to responses during other shocks. Liquidation of assets and withdrawals from financial market were severe, which made a risky group of borrowers have difficulties rolling over their liabilities and financing new credits. A recent development in theory explains various mechanisms which led to enhanced initial effects of a flight-to-quality pattern. These mechanisms follow from an observation that a flight-to-quality pattern involves a combination of market participants' weakening
balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a busine ...
and
risk aversion In economics and finance, risk aversion is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more ce ...
of asset payoffs, extreme uncertainty aversion, and strategic or speculative behavior of liquid market participants. A "balance sheet mechanism" focuses on institutional features of financial markets. It provides an explanation for feedback loop mechanisms between the asset prices and balance sheets, and investors' preference for liquidity. The idea is that if investors' balance sheets depend on asset prices under delegated investment management, then a negative asset price shock tightens the investors' balance sheets, forcing them to liquidate assets, and makes investors prefer more liquid and less risky assets. Forced liquidation and changes in investors' preferences further lower asset prices and deteriorate the balance sheets, amplifying the initial shock. Vayanos models how a relationship between fund managers and clients can lead to effective risk aversion when illiquidity risk rises due to asset price volatility. He and Krishnamurthy introduce
principal–agent problem The principal–agent problem refers to the conflict in interests and priorities that arises when one person or entity (the "Agent (economics), agent") takes actions on behalf of another person or entity (the "Principal (commercial law), princip ...
to a model to show how specialists’ capital investments are pro-cyclical. Brunnermeier and Pedersen model
margin requirement In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consump ...
and show how volatility of asset prices tightens the requirement that lead to asset sales. An "information amplification mechanism" focuses on a role of investor's extreme uncertainty aversion. When an unusual and unexpected event incurs losses, investors find that they do not have a good understanding about the tail outcome that they are facing and treat the risk as Knightian uncertainty. An example is
subprime mortgage crisis The United States subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010 that contributed to the Financial crisis of 2007–2008, 2007–2008 global financial crisis. It was triggered by a large decline ...
in 2008. Investors realized that they did not have good understanding about
mortgage-backed securities A mortgage-backed security (MBS) is a type of asset-backed security An asset-backed security (ABS) is a security Security is protection from, or resilience against, potential harm (or other unwanted Coercion, coercive change) caused by othe ...
which were newly adopted. Newly adopted financial innovation meant that market participants had only a short time to formulate valuation, and did not have enough history to refer to in their risk management and hedging models. Under Knightian uncertainty, investors respond by disengaging from risky activities and hoarding liquidity while reevaluating their investment models. They only take conservative approaches, investing on only safe and uncontingent claims, to protect themselves from worst-case scenarios related to the risk that they do not understand, which further deteriorates asset prices and financial market. A model of strategic or speculative behaviors of liquid investors provides another mechanism that explains flight-to-quality phenomenon. Acharya ''et al'' show that during financial turmoil liquid banks in interbank loan markets do not lend their liquidity to illiquid banks, nor hoard liquidity for precautionary reasons, but, rather, hoard them to purchase assets at distress prices. Brunnermeier and Pedersen study strategic behaviors of liquid traders when they know that other traders need to liquidate their positions. The study shows that the strategic behaviors would lead to predatory pricing, which would lead the price of risky and illiquid assets to fall further than they would if price were based on risk consideration alone.


Empirical studies

Since flight-to-quality phenomenon implies a shift in investing behavior towards some safe group of assets from risky assets, efforts to find evidence on flight-to-quality have been concentrated on analyzing widening yields or quantity changes between two assets. A number of studies find stronger negative association between stock and bond markets during a financial turmoil. Flight-to-quality is also observable within a safe group of assets. Longstaff finds a spread between Resolution Funding Corporation bonds, whose liabilities are guaranteed by Treasury, and US Treasury bonds increases when consumer confidence drops, money market mutual funds and Treasury buy backs increase. Krishnamurthy compares on-the-run and off-the-run treasury bonds to find higher spreads on off-the –run bonds are associated with higher spread between commercial paper and Treasury bonds. Beber ''et al'' make explicit distinction between flight-to-quality and flight-to-liquidity and find relative importance of liquidity over credit quality rises during flight-to-quality episodes. Gatev and Strahan find that the spread between treasury bills and high grade
commercial paper Commercial paper, in the global financial market, is an Unsecured debt, unsecured promissory note with a fixed Maturity (finance), maturity of rarely more than 270 days. In layperson terms, it is like an "wikt:IOU, IOU" but can be bought and so ...
increases, banks tend to experience inflow of deposits and decreased cost of funding. This suggests that banks tend to be seen as safe havens in periods of turmoil. However, data shows that during 1998 the flight-to-quality episodes worsening relative position of banks compared to the very safe assets.


Real sector effects

During a flight-to-quality episode external financing becomes harder for lower quality borrowers or riskier projects. Investors faced with tightened balance sheet and increased risk and uncertainty aversion reduce their investment and shift their portfolio only towards safer projects and high quality borrowers. Tightening external financing for lower quality borrowers may extend to real consequences of output loss and higher unemployment, therefore exacerbate business cycle. A series of studies show that amount and composition of firm's external financing from bank loans are countercyclical during flight-to quality periods. Kashyap ''et al'' finds that quantity of commercial paper issuances of high quality firms increase relative to bank loans. Since lower quality firms lack external financing ability via commercial paper issuance, lower quality firms are likely to be deprived from financial resources. Gertler and Gilchrist find similar result of relative proportion of loans being increased to larger firms, and Oliner and Rudebusch find new loans made to safer projects are countercyclical during flight-to-quality episodes. Bernanke ''et al'' compare differences in performances between small and large firms during a flight-to-quality episode, and find evidence that the differences explain as much as one third of aggregate fluctuations.


Policy implications

A
moral hazard In economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the ...
concern generally provides a rationale that government should not intervene in a financial crisis. The argument is that a market participant who expects government
bailout A bailout is the provision of financial help to a corporation or country which otherwise would be on the brink of bankruptcy. A bailout differs from the term ''bail-in'' (coined in 2010) under which the bondholders or depositors of global syst ...
s or emergency financing would engage in excessive risk taking. However, various government policy tools have been proposed to alleviate the effect of flight-to-quality phenomenon. The argument for
government intervention Economic interventionism, sometimes also called state interventionism, is an Economic policy, economic policy position favouring government intervention in the Market (economics), market process with the intention of correcting market failures a ...
is that flight-to-quality phenomenon is a result of insufficient risk taking generated by Knightian uncertainty. There is also an inefficiency issue generated by
externality In economics, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's (or parties') activity. Externalities can be considered as unpriced goods involved in either co ...
that supports rationale for prudential policy. The externality is generated when in presence of illiquid market, each firm forced to sell illiquid assets depresses prices for everyone else but does not take this effect into account in its decision-making. The externality also enables strategic and speculative behaviors of liquid investors. Caballero and Krishnamurthy show that central bank acting as a
lender of last resort A lender of last resort (LOLR) is the institution in a financial system that acts as the provider of Accounting liquidity, liquidity to a financial institution which finds itself unable to obtain sufficient liquidity in the interbank lending m ...
would be effective when both balance sheet and information amplifier mechanisms are at work. For instance, a
guarantee Guarantee is a legal term more comprehensive and of higher import than either warranty or "security". It most commonly designates a private transaction by means of which one person, to obtain some trust, confidence or credit for another, engages ...
issuance by government or loans to distressed private sectors would sustain deteriorating asset prices, bring confidence back in financial market, and prevent
fire sale A fire sale is the sale of goods at extremely discounts and allowances, discounted prices. The term originated in reference to the sale of goods at a heavy discount due to fire damage. It may or may not be defined as a Closeout (sale), closeout, ...
of assets. Brock and Manski argue that government's guarantee on minimum returns on investment can restore investor's confidence when Knightian uncertainty is prevalent. Acharya ''et al'' argue that the central bank's role as a lender of last resort can also support smooth functioning of interbank markets. The loan from the central bank to distressed banks would improve their outside option in bargaining. Thus less efficient asset sales would not be necessary and liquid banks would not be able to behave monopolistically. Brunnermeier and PedersenBrunnermeier, Markus and Lasse Pedersen (2005) "Predatory Trading." The Journal of Finance, 60(4), 1825-1863. propose short selling restrictions and trading halts to eliminate predatory behaviors of liquid traders.


External links


A Primer on Flight to Quality


References

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