Strategic complementarity, fragility, and regulation

No D/928, IESE Research Papers from 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.

Keywords: stress; crises; illiquidity risk; insolvency risk; leverage ratio; liquidity ratio; derivatives market; disclosure (search for similar items in EconPapers)
Pages: 50 pages
Date: 2011-06-05
New Economics Papers: this item is included in nep-ban and nep-cta
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (17)

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Related works:
Journal Article: Strategic Complementarity, Fragility, and Regulation (2014)
Working Paper: Strategic Complementarity, Fragility, and Regulation (2012)
Working Paper: Strategic Complementarity, Fragility, and Regulation (2011)
Working Paper: Strategic Complementarity, Fragility, and Regulation (2011)
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Persistent link: https://EconPapers.repec.org/RePEc:ebg:iesewp:d-0928

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