1.    When an asset-price bubble bursts and asset prices realign with fundamental economic values, the resulting decline in net worth means that businesses have less skin in the game and so have incentives to take on more risk at the lender’s expense, increasing the moral hazard problem. In addition, lower net worth means there is less collateral and so adverse selection increases. The bursting of an asset-price bubble therefore makes borrowers less credit-worthy and causes a contraction in lending and spending. The asset price bust can also lead to a deterioration in financial institutions’ balance sheets, which causes them to deleverage, further contributing to the decline in lending and economic activity.

2.     An unanticipated decline in the price level leads to firms’ real burden of indebtedness increasing while there is no increase in the real value of their assets. The resulting decline in firms’ net worth increases adverse selection and moral hazard problems facing lenders, making it more likely a financial crisis will occur in which financial markets do not work efficiently to get funds to firms with productive investment opportunities.

3.     Asymmetric information problems (adverse selection and moral hazard) are always present in financial transactions but normally do not prevent the financial system from efficiently channeling funds from lender-savers to borrowers. During a financial crisis, however, asymmetric information problems intensify to such a degree that the resulting financial frictions lead to flows of funds being halted or severely disrupted, with harmful consequences for economic activity.

4.     A decline in real estate prices lowers the net worth of households or firms that are holding real estate assets. The resulting decline in net worth means that businesses have less at risk and so have more incentives to take on risk at the lender’s expense. In addition, lower net worth means there is less collateral and so adverse selection increases. The decline in real estate prices can thus make borrowers less credit-worthy and cause a contraction in lending and spending. The real estate decline can also lead to a deterioration in financial institutions’ balance sheets, which causes them to deleverage, further contributing to the decline in lending and economic activity.

5.     If financial institutions suffer a deterioration in their balance sheets and they have a substantial contraction in their capital, they will have fewer resources to lend, and lending will decline. The contraction in lending then leads to a decline in investment spending, which slows economic activity. When there are simultaneous failures of financial institutions, there is a loss of information production in financial markets and a direct loss of banks’ financial intermediation. In addition, a decrease in bank lending during a banking crisis decreases the supply of funds available to borrowers, which leads to higher interest rates, which increases asymmetric information problems and leads to a further contraction in lending and economic activity.

6.     The failure of a major financial institution, which leads to a dramatic increase in uncertainty in financial markets, makes it hard for lenders to screen good from bad credit risks. The resulting inability of lenders to solve the adverse selection problem makes them less willing to lend, which leads to a decline in lending, investment, and aggregate economic activity.

7.    Credit spreads measure the difference between interest rates on corporate bonds and Treasury bonds of similar maturity that have no default risk. The rise of credit spreads during a financial crisis (as occurred during the Great Depression and again during 2007–2009) reflects the escalation of asymmetric information problems that make it harder to judge the riskiness of corporate borrowers and weaken the ability of financial markets to channel funds to borrowers with productive investment opportunities.