Dissecting Mechanisms of Financial Crises: Intermediation and Sentiment

74 Pages Posted: 9 Apr 2020 Last revised: 25 Oct 2021

See all articles by Arvind Krishnamurthy

Arvind Krishnamurthy

Stanford Graduate School of Business

Wenhao Li

University of Southern California - Marshall School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: May 12, 2021

Abstract

We develop a model of financial crises with both a financial amplification mechanism, via frictional intermediation, and a role for sentiment, via time-varying beliefs about an illiquidity state. We confront the model with data on credit spreads, equity prices, credit, and output across the financial crisis cycle. In particular, we ask the model to match data on the frothy pre-crisis behavior of asset markets and credit, the sharp transition to a crisis where asset values fall, disintermediation occurs and output falls, and the post-crisis period characterized by a slow recovery in output. Our model with the frictional intermediation mechanism and fluctuations in beliefs provides a parsimonious account of the entire crisis cycle. The model with only the frictional intermediation mechanism misses the frothy pre-crisis behavior; fluctuations in beliefs resolve this problem. On the other hand, modeling the belief variation via {\it either} a Bayesian or diagnostic model match the broad patterns, with each missing some targets to different extents. We also show that a lean-against-the-wind policy has a quantitatively similar impact in both versions of the belief model, indicating that policy need not ``get into the minds" of investors and condition on the true belief process.

Keywords: financial crises, intermediation, sentiment, credit spread

JEL Classification: G01, E44

Suggested Citation

Krishnamurthy, Arvind and Li, Wenhao, Dissecting Mechanisms of Financial Crises: Intermediation and Sentiment (May 12, 2021). Available at SSRN: https://ssrn.com/abstract=3554788 or http://dx.doi.org/10.2139/ssrn.3554788

Arvind Krishnamurthy

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

Wenhao Li (Contact Author)

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd
Los Angeles, CA California 90089
United States

HOME PAGE: http://www.wenhao-li.com

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
489
Abstract Views
2,148
rank
74,989
PlumX Metrics