Strategic complementarity, fragility, and regulation

Arbeitspapier

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.

Object Details

• Language: Englisch

References and Relationships

• Bibliographic citation: Series: CESifo Working Paper ; No. 3507

Classification and Topics

• Classification: Wirtschaft ; Banks; Depository Institutions; Micro Finance Institutions; Mortgages ; Financial Institutions and Services: Government Policy and Regulation
• Subject: stress ; crises ; illiquidity risk ; insolvency risk ; leverage ratio ; liquidity ratio ; disclosure ; transparency ; opaqueness ; panic ; run ; derivatives market ; Finanzmarktkrise ; Anlageverhalten ; Spieltheorie ; Marktliquidität ; Risiko ; Kreditrisiko ; Bankenkrise ; Finanzmarkt ; Regulierung ; Hybrides Finanzprodukt ; Asset-backed security ; Commercial Paper ; Theorie ; Welt

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Vives, Xavier
• Event: Veröffentlichung
• (who): Center for Economic Studies and ifo Institute (CESifo)
• (where): Munich
• (when): 2011

Further information

• Handle: http://hdl.handle.net/10419/49495
• Last update: 10.03.2025, 11:43 AM CET