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A Model of Capital and Crises

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  • Zhiguo He
  • Arvind Krishnamurthy
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    Abstract

    We develop a model in which the capital of the intermediary sector plays a critical role in determining asset prices. The model is cast within a dynamic general equilibrium economy, and the role for intermediation is derived endogenously based on optimal contracting considerations. Low intermediary capital reduces the risk-bearing capacity of the marginal investor. We show how this force helps to explain patterns during financial crises. The model replicates the observed rise during crises in Sharpe ratios, conditional volatility, correlation in price movements of assets held by the intermediary sector, and fall in riskless interest rates.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14366.

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    Date of creation: Sep 2008
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    Publication status: published as A Model of Capital and Crises, 2012, with Arvind Krishnamurthy, Review of Economic Studies 79(2): pp. 735-777. Presentation Slides.
    Handle: RePEc:nbr:nberwo:14366

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    Cited by:
    1. Shleifer, Andrei & Vishny, Robert W., 2010. "Unstable banking," Journal of Financial Economics, Elsevier, Elsevier, vol. 97(3), pages 306-318, September.
    2. Lee, King Fuei, 2010. "Demographics, dividend clienteles and the dividend premium," MPRA Paper, University Library of Munich, Germany 34546, University Library of Munich, Germany.
    3. Bacchetta, Philippe & Tille, Cédric & van Wincoop, Eric, 2010. "Self-Fulfilling Risk Panics," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7920, C.E.P.R. Discussion Papers.
    4. Bruno Biais & Jean-Charles Rochet & Paul Woolley, 2010. "Innovations, rents and risk," FMG Discussion Papers, Financial Markets Group dp659, Financial Markets Group.
    5. Mancini Griffoli, Tommaso & Ranaldo, Angelo, 2012. "Limits to Arbitrage during the Crisis: Finding Liquidity Constraints and Covered Interest Parity," Working Papers on Finance, University of St. Gallen, School of Finance 1212, University of St. Gallen, School of Finance.
    6. Sylvain Champonnois, 2011. "The limits of market discipline: proprietary trading and aggregate risk," 2011 Meeting Papers, Society for Economic Dynamics 1013, Society for Economic Dynamics.
    7. Tianxi Wang, 2009. "Risk, Leverage, and Regulation of Financial Intermediaries," Economics Discussion Papers, University of Essex, Department of Economics 678, University of Essex, Department of Economics.
    8. Asani Sarkar, 2009. "Liquidity risk, credit risk, and the federal reserve’s responses to the crisis," Financial Markets and Portfolio Management, Springer, Springer, vol. 23(4), pages 335-348, December.
    9. Dubecq, S. & Mojon, B. & Ragot, X., 2009. "Fuzzy Capital Requirements, Risk-Shifting and the Risk Taking Channel of Monetary Policy," Working papers, Banque de France 254, Banque de France.

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