"The first mechanism works through asset prices and balance sheets. A negative shock to the balance sheets of asset-holders causes them to liquidate assets, lowering prices, further deteriorating balance sheets, culminating in a crisis. The second mechanism involves investors' Knightian uncertainty. Unusual shocks to untested financial innovations lead agents to become uncertain about their investments causing them to disengage from markets and increase their demand for liquidity. This behavior leads to a loss of liquidity and a crisis."
He writes that the balance sheet mechanism creates an endogenous source of liquidation shocks that depends on the leverage of agents. Also, uncertainty inhibits the process of price discovery, rendering market prices uninformative about fundamental value, and thereby triggering off a positive feedback loop on uncertainty. Further, as in the case of the sub-prime mortgage crisis, the downward spiral in asset prices started with uncertainty about counter party risks (due in part to the complexity of credit market instruments) which soon became evident on the balance sheets as a balance-sheet/asset-price feedback was set in motion. Accounting rules like Mark-to-Market (information revealed from which are difficult to interpret in an environment where the price discovery mechanism is impaired) is an important mechanism through which balance sheet amplifiers are triggered off.
About recovery from an uncertainty-driven crisis, he writes that it is
"only resolved over time as investors understand where they went wrong and formulate new models of the world; in short, as the uncertainty is resolved. Part of this process involves information revelation. What mistakes have investors made? Which investors have large exposures to the relevant assets, and how big are their losses? In an environment where the price discovery mechanism is impaired, information revealed from accounting statements is hard to interpret. Further, in an environment where balance sheets are weak, a financial institution may be reluctant to realize losses, impeding information revelation. These forces tend to perpetuate an uncertain environment, which may be one factor behind the duration of the subprime crisis. Indeed, from this perspective, a benefit of the stress-tests performed by the Treasury in the current crisis is that they force information revelation and reduce uncertainty."
Mostly Economics has more on "how changes in asset prices are transmitted internationally through their effects on the balance sheets of highly leveraged financial institutions" and points to two papers.
First, Michael B. Devereux of the University of British Columbia, has a paper that develops a "model of the international transmission of shocks through de-leveraging across financial institutions". He writes, "In a macro-economic model in which highly levered investors hold interconnected portfolios across countries, we show that the presence of binding leverage constraints introduces a powerful financial transmission channel which results in a high correlation among macroeconomic aggregates during business cycle downturns, quite independent of the size of international trade linkages."
Second, Paul Krugman was one of the first to point to an international finance multiplier, different from the conventional foreign trade multiplier, that palys an increasingly important role in linking markets together and enabling the transmission of global economic shocks. He defines an international finance multiplier, as that "in which changes in asset prices are transmitted internationally through their effects on the balance sheets of highly leveraged financial institutions". The multiplier effect is transmitted through, what Kaminsky, Reinhart, and Vegh describes as the "leveraged common creditor". Prof Krugman therefore argues that since all economies now share leveraged common creditors, balance sheet contagion has become pervasive.
I have blogged about this in an early post here.