We introduce Knightian uncertainty into a standard global game framework to propose a new amplification mechanism of financial crises. In the model, ambiguity-averse speculators are uncertain about the accuracy of a public signal. They shift more weight to the public signal when it is deteriorating. In the equilibrium, a public signal cut-off characterises the coordination attack against the regime. Below (above) the cut-off, there is a weak (strong) regime in which the public signal is more (less) pronounced. For an outside observer, there is an asymmetric amplification of the financial crisis. We derive the magnitude of amplification and study its property. To enhance financial stability, a policymaker may clarify the source of a public rumour.

This article uses FAS 123R regulation to examine how reduction in CEO compensation incentives affects managerial “playing it safe” behavior. Using proxies reflecting deliberate managerial efforts to change firm risk, difference-in-difference tests show that affected firms drastically reduce both systematic and idiosyncratic risks, leading to an 8% decline in total firm risk. These reductions in risk are achieved by shifting to safer, but low-Q, segments while closing the riskier ones, without significant changes in investment levels. Our findings suggest that decrease in risk-taking incentives provided by option compensation, when not compensated for by alternative incentives or governance mechanisms, exacerbates risk-related agency problem.