One of the mechanisms, that can work to amplify the effects of a small negative shock to the economy, is the balance sheet mechanism. Under this mechanism, a negative shock in the financial market lowers asset prices and erodes the financial institution's capital, thus worsening its balance sheet. Consequently, two liquidity spirals come into effect, which amplify the impact of the initial negative shock. In an attempt to maintain its leverage ratio, the financial institution must sell its assets, precisely at a time when their price is low. Thus, assuming that asset prices depend on the health of investors' balance sheet, erosion of investors' net worth further reduces asset prices, which feeds back into their balance sheet and so on. This is what Brunnermeier and Pedersen (2008) term as the "loss spiral". At the same time, lending standards and margins tighten, leading to the "margin spiral". Both these effects cause the borrowers to engage in a fire sale, lowering prices and deteriorating external financing conditions.
