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Strategic Complementarity, Fragility, and Regulation

50 Pages Posted: 21 Oct 2011  

Xavier Vives

University of Navarra - IESE Business School; Universitat Pompeu Fabra (UPF); Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

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Date Written: October, 21 2011

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.

Keywords: stress, crises, illiquidity risk, insolvency risk, leverage ratio, liquidity ratio, disclosure, transparency, opaqueness, panic, run, derivates market

JEL Classification: G21, G28

Suggested Citation

Vives, Xavier, Strategic Complementarity, Fragility, and Regulation (October, 21 2011). IESE Business School Working Paper No. 928. Available at SSRN: https://ssrn.com/abstract=1947313 or http://dx.doi.org/10.2139/ssrn.1947313

Xavier Vives (Contact Author)

University of Navarra - IESE Business School ( email )

Avenida Pearson 21
Barcelona, 08034
Spain

HOME PAGE: http://wwwapp.iese.edu/faculty/facultyDetail.asp?lang=en&prof=xv

Universitat Pompeu Fabra (UPF) ( email )

Ramon Trias Fargas, 25-27
Barcelona, 08005
Spain

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute for Economic Research) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

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