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A Model of Capital and Crises

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  • Zhiguo He
  • Arvind Krishnamurthy

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.

Suggested Citation

  • Zhiguo He & Arvind Krishnamurthy, 2008. "A Model of Capital and Crises," NBER Working Papers 14366, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:14366
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    Cited by:

    1. Philippe Bacchetta & Cédric Tille & Eric van Wincoop, 2012. "Self-Fulfilling Risk Panics," American Economic Review, American Economic Association, vol. 102(7), pages 3674-3700, December.
    2. Bruno Biais & Jean-Charles Rochet & Paul Woolley, 2010. "Innovations, rents and risk," FMG Discussion Papers dp659, Financial Markets Group.
    3. Tommaso Mancini Griffoli & Angelo Ranaldo, 2010. "Limits to arbitrage during the crisis: funding liquidity constraints and covered interest parity," Working Papers 2010-14, Swiss National Bank.
    4. Tianxi, Wang, 2009. "Risk, Leverage, and Regulation of Financial Intermediaries," MPRA Paper 18212, University Library of Munich, Germany.
    5. Araújo, Eliane & Bruno, Miguel & Pimentel, Débora, 2012. "Financialization against Industrialization: a regulationnist approach of the Brazilian Paradox," Revue de la Régulation - Capitalisme, institutions, pouvoirs, Association Recherche et Régulation, vol. 11.
    6. Asani Sarkar, 2009. "Liquidity risk, credit risk, and the federal reserve’s responses to the crisis," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 23(4), pages 335-348, December.
    7. Lee, King Fuei, 2011. "Demographics, dividend clienteles and the dividend premium," The Quarterly Review of Economics and Finance, Elsevier, vol. 51(4), pages 368-375.
    8. Sylvain Champonnois, 2011. "The limits of market discipline: proprietary trading and aggregate risk," 2011 Meeting Papers 1013, Society for Economic Dynamics.
    9. Dubecq, S. & Mojon, B. & Ragot, X., 2009. "Fuzzy Capital Requirements, Risk-Shifting and the Risk Taking Channel of Monetary Policy," Working papers 254, Banque de France.
    10. Shleifer, Andrei & Vishny, Robert W., 2010. "Unstable banking," Journal of Financial Economics, Elsevier, vol. 97(3), pages 306-318, September.
    11. Wang, T, 2009. "Risk, Leverage, and Regulation of Financial Intermediaries," Economics Discussion Papers 2958, University of Essex, Department of Economics.

    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G2 - Financial Economics - - Financial Institutions and Services

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