A Model of Capital and Crises
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
nancial 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. In a dynamic context, we show
that aversion to drops in intermediary capital can generate a two-factor asset pricing model with
a role for both a market factor and a liquidity factor.
He, Zhiguo and Arvind Krishnamurthy. 2012. A Model of Capital and Crises. Review of Economic Studies. 79(2): 735-777.