This approach departs from the conventional market efficiency view that rational traders will immediately stabilise prices by shortening overvalued assets and, by contrast, integrates important aspects of trading behaviour into the mainstream of economics and finance. When a bubble bursts and risk is re-assessed, financial institutions suffer losses.
In the current crisis, uncertainty over the size and location of exposures of banks or banksponsored conduits to “toxic” assets translated into funding liquidity problems. A paper by Brunnermeier and Pedersen, “Market Liquidity and Funding Liquidity” explains how such funding problems can affect market liquidity and lead to mutually reinforcing liquidity spirals.