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Strategic complementarity, fragility, and regulation

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  • Vives, Xavier

    () (IESE Business School)

Abstract

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.

Suggested Citation

  • Vives, Xavier, 2011. "Strategic complementarity, fragility, and regulation," IESE Research Papers D/928, IESE Business School.
  • Handle: RePEc:ebg:iesewp:d-0928
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    References listed on IDEAS

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    Cited by:

    1. Marco di Maggio & Marco Pagano, 2012. "Financial Disclosure and Market Transparency with Costly Information Processing," CSEF Working Papers 323, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy, revised 23 Jul 2016.
    2. repec:wly:iecrev:v:57:y:2016:i::p:1135-1148 is not listed on IDEAS
    3. Martin Ellison & Andreas Tischbirek, 2018. "Beauty Contests and the Term Structure," Economics Series Working Papers 846, University of Oxford, Department of Economics.
    4. repec:eee:macchp:v2-2263 is not listed on IDEAS
    5. Allen, Franklin & Carletti, Elena & Goldstein, Itay & Leonello, Agnese, 2015. "Government Guarantees and Financial Stability," CEPR Discussion Papers 10560, C.E.P.R. Discussion Papers.
    6. Giancarlo Corsetti & Michael P. Devereux & John Hassler & Gilles Saint-Paul & Hans-Werner Sinn & Jan-Egbert Sturm & Xavier Vives, 2011. "Chapter 5: Taxation and Regulation of the Financial Sector," EEAG Report on the European Economy, CESifo Group Munich, vol. 0, pages 147-169, February.
    7. Szkup, Michal, 2017. "Multiplier effect and comparative statics in global games of regime change," MPRA Paper 82729, University Library of Munich, Germany.
    8. Douglas W. Diamond & Anil K. Kashyap, 2016. "Liquidity Requirements, Liquidity Choice and Financial Stability," NBER Working Papers 22053, National Bureau of Economic Research, Inc.
    9. Diana Bonfim & Moshe Kim, 2012. "Liquidity risk in banking: is there herding?," Working Papers w201218, Banco de Portugal, Economics and Research Department.
    10. repec:eee:ecmode:v:64:y:2017:i:c:p:172-177 is not listed on IDEAS
    11. Gabriel Jiménez & Steven Ongena & José-Luis Peydró & Jesús Saurina, 2017. "Do demand or supply factors drive bank credit,in good and crisis times?," Economics Working Papers 1567, Department of Economics and Business, Universitat Pompeu Fabra.
    12. Christian Calmès & Raymond Théoret, 2011. "Bank systemic risk and the business cycle: An empirical investigation using Canadian data," RePAd Working Paper Series UQO-DSA-wp322011, Département des sciences administratives, UQO.
    13. Ellison, Martin & Tischbirek, Andreas, 2018. "Beauty contests and the term structure," LSE Research Online Documents on Economics 87384, London School of Economics and Political Science, LSE Library.
    14. Lars Calmfors & Giancarlo Corsetti & John Hassler & Gilles Saint-Paul & Hans-Werner Sinn & Jan-Egbert Sturm & Ákos Valentinyi & Xavier Vives, 2012. "Chapter 3: Banking Regulation," EEAG Report on the European Economy, CESifo Group Munich, vol. 0, pages 83-98, February.
    15. Diana Bonfim & Moshe Kim, 2012. "Systemic Liquidity Risk," Economic Bulletin and Financial Stability Report Articles, Banco de Portugal, Economics and Research Department.
    16. Giuliana Birindelli & Paola Ferretti & Marco Savioli, 2016. "Basel 3: Does One Size Really Fit All Banks' Business Models?," Working Paper series 16-20, Rimini Centre for Economic Analysis.
    17. Toni Ahnert & Co-Pierre Georg, 2017. "Information Contagion and Systemic Risk," Staff Working Papers 17-29, Bank of Canada.
    18. Stephen Morris & Hyun Song Shin, 2016. "Illiquidity Component Of Credit Risk," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 57, pages 1135-1148, November.
    19. Laurent Clerc & Alberto Giovannini & Sam Langfield & Tuomas Peltonen & Richard Portes & Martin Scheicher, 2016. "Indirect contagion: the policy problem," ESRB Occasional Paper Series 09, European Systemic Risk Board.
    20. Emily Gallagher & Sean Collins, 2016. "Money Market Funds and the Prospect of a US Treasury Default," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 6(01), pages 1-44, March.

    More about this item

    Keywords

    stress; crises; illiquidity risk; insolvency risk; leverage ratio; liquidity ratio; derivatives market; disclosure;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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