I wrote about both Knightian uncertainty--as opposed to risk--here (referencing Keynes) and stress-testing here. In a very good speech, the RBA's Guy Debelle touches on both again here. He also posits that it is not socially optimal for financial institutions to fully self-insure. Put differently, at some point taxpayers will need to back these institutions, as I have noted many times here (for a price, of course). In Guy's words:
"While these measures work to increase the robustness at an institutional level, in the event of a system-wide event, such as took place in 2008, a different set of considerations come into play. Once a systemic shock of that nature occurs, it requires a systemic response, which ultimately must come from the public sector, including the central bank, which has the capacity to respond. The institutional framework determines the point at which the public sector needs to be called on. But in terms of insurance of the system as a whole, at some point, it has to be provided by the public sector.
I do not believe it is socially optimal for the individual entity to fully insure itself. It would be excessively costly for the financial sector to hold enough capital and liquidity to enable it to survive a freezing of capital markets of the type that occurred in 2008. At some point, it is not even affordable. As Ricardo Caballero puts it, the presence of ‘Knightian uncertainty [means] that scarce capital is wasted insuring against impossible events’.10
Financial services are a key intermediary input into the production process. A severe curtailment of those services has a material impact on the capital accumulation process, unemployment and the long-run growth prospects of the economy. It is in the interests of society to ensure that the public sector provides a backstop in such circumstances to mitigate the externality caused by the individually rational risk-aversion of financial sector participants.
Finally, the financial innovation of the decade or so prior to 2007 saw the development of a large number of derivative products whose goal was to disperse risk around the financial system. This was done, in part, to enhance the robustness of the system to any idiosyncratic shock and to ensure that the core process of financial intermediation was not significantly compromised when the shock hit. This worked up to a point, in that the situation, as bad as it was, may have been even worse if all the losses resided on the books of financial intermediaries rather than also on the books of pension funds etc, where the immediate effect of the losses was diffused somewhat (although less of it turned out to be diffused than originally thought). Whether this is true or not will be an interesting research question in the years ahead."
