The 'surprising' origin and nature of financial crises

the long version

Severe financial crises in developed economies are produced by a combination of three factors: negative surprises that create uncertainty, concentration of macroeconomic risk in leveraged financial institutions and a slow policy response. We propose a policy instrument, Tradable Insurance Credits (TICs), designed to address crises stemming from these factors. TICs would be issued by the central bank and give their holder the right to attach a central bank guarantee to assets on its balance sheet, but only during a financial crisis; financial institutions would be required to keep a minimum holding of TICs. TIC policy could be carried out in a similar way to monetary policy and fits into existing institutional frameworks; we examine how TICs could have been used to address the 2007-2009 financial crisis in a faster and more systematic way than the ad-hoc measures undertaken. Keywords: financial crises, Knightian uncertainty, macroeconomic risk, credit default swaps, asset insurance. JEL Classifications: G01, G28, E58.