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Strategic Complementarity, Fragility, and Regulation

  • Xavier Vives

    (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 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). The model is applied to interpret the 2007 run on SIV and ABCP conduits.

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Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 789.

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Date of creation: 2012
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Handle: RePEc:red:sed012:789
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