The initial effects of these events were a fall in asset prices and aggregate quantity of liquidity in financial market which deteriorated balance sheets of both borrowers and investors.
Worsening of initial impacts developed into a flight-to-quality pattern, as the unusual and unexpected features of the events made market participants more risk and uncertainty averse, incurring more aggressive reactions compared to responses during other shocks.
Liquidation of assets and withdrawals from financial market were severe, which made a risky group of borrowers have difficulties rolling over their liabilities and financing new credits.
Forced liquidation and changes in investors' preferences further lower asset prices and deteriorate the balance sheets, amplifying the initial shock.
When an unusual and unexpected event incurs losses, investors find that they do not have a good understanding about the tail outcome that they are facing and treat the risk as Knightian uncertainty.
Newly adopted financial innovation meant that market participants had only a short time to formulate valuation, and did not have enough history to refer to in their risk management and hedging models.
They only take conservative approaches, investing on only safe and uncontingent claims, to protect themselves from worst-case scenarios related to the risk that they do not understand, which further deteriorates asset prices and financial market.
Gatev and Strahan[12] find that the spread between treasury bills and high grade commercial paper increases, banks tend to experience inflow of deposits and decreased cost of funding.
Investors faced with tightened balance sheet and increased risk and uncertainty aversion reduce their investment and shift their portfolio only towards safer projects and high quality borrowers.
Tightening external financing for lower quality borrowers may extend to real consequences of output loss and higher unemployment, therefore exacerbate business cycle.
A series of studies show that amount and composition of firm's external financing from bank loans are countercyclical during flight-to quality periods.
Kashyap et al[14] finds that quantity of commercial paper issuances of high quality firms increase relative to bank loans.
Caballero and Krishnamurthy[19] show that central bank acting as a lender of last resort would be effective when both balance sheet and information amplifier mechanisms are at work.
Brock and Manski[20] argue that government's guarantee on minimum returns on investment can restore investor's confidence when Knightian uncertainty is prevalent.