Strategic Complementarity, Fragility, and Regulation

Xavier Vives

No 8444, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: The paper analyzes a very stylized model of crises and demonstrates how the degree of strategic complementarity in the actions of investors is an important determinant of fragility. It is shown how the balance sheet composition of a financial intermediary, parameters of the information structure (precisions of public and private information), and the level of stress indicators in the market impinge on strategic complementarity and fragility. The model distinguishes between solvency and liquidity risk and characterizes them. Both a solvency (leverage) and a liquidity ratio are required to control the probabilities of insolvency and illiquidity. It is found that in a more competitive environment (with higher return on short-term debt) the solvency requirement has to be strengthened, and in an environment where the fire sales penalty is higher and fund managers are more conservative the liquidity requirement has to be strengthened while the solvency one relaxed. Higher disclosure or introducing a derivatives market may backfire, aggravating fragility (in particular when the asset side of a financial intermediary is opaque). It is found that the regulator should set together disclosure and prudential policy. The model is applied to interpret the 2007 run on SIV and ABCP conduits.

Keywords: Crises; Disclosure; Illiquidity risk; Insolvency risk; Leverage ratio; Liquidity ratio; Opaqueness; Panic; Run; Stress (search for similar items in EconPapers)
JEL-codes: G21 G28 (search for similar items in EconPapers)
Date: 2011-06
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Citations: View citations in EconPapers (14)

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Related works:
Journal Article: Strategic Complementarity, Fragility, and Regulation (2014)
Working Paper: Strategic Complementarity, Fragility, and Regulation (2012)
Working Paper: Strategic Complementarity, Fragility, and Regulation (2011)
Working Paper: Strategic complementarity, fragility, and regulation (2011)
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