A flight-to-quality, or flight-to-safety, is a financial market phenomenon occurring when investors sell what they perceive to be higher-risk investments and purchase safer investments, such as gold and other precious metals. This is considered a sign of fear 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’s default in 1970, a sudden stock market crash referred to as Black Monday, the Russian debt default and collapse of Long Term Capital Management in 1998, the 9/11 attack in 2001, and the subprime mortgage crisis 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 in financial market 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 and risk aversion 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 to a model to show how specialists’ capital investments are pro-cyclical. Brunnermeier and Pedersen model margin requirement and show how volatility of asset prices tightens the requirement that lead to asset sales.