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Strategic complementarity, fragility, and regulation

  • Vives, Xavier

    ()

    (IESE Business School)

The paper analyzes a very stylized model of crises and demonstrates how the degree of strategic complementarity in the actions of investors is a critical 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 the degree of strategic complementarity. 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) and, correspondingly, liquidity requirements should be tightened. The model is applied to interpret the 2007 run on SIV and ABCP conduits.

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Paper provided by IESE Business School in its series IESE Research Papers with number D/928.

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Length: 50 pages
Date of creation: 05 Jun 2011
Date of revision:
Handle: RePEc:ebg:iesewp:d-0928
Contact details of provider: Postal: IESE Business School, Av Pearson 21, 08034 Barcelona, SPAIN
Web page: http://www.iese.edu/

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