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Title:Strategic complementarity, fragility, and regulation PDF Logo
Authors:Vives, Xavier
Issue Date:2011
Series/Report no.:CESifo working paper: Monetary Policy and International Finance 3507
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.
Subjects:stress
crises
illiquidity risk
insolvency risk
leverage ratio
liquidity ratio
disclosure
transparency
opaqueness
panic
run
derivatives market
JEL:G21
G28
Document Type:Working Paper
Appears in Collections:CESifo Working Papers, CESifo Group Munich

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