Financial products and the markets in which they are traded have long been among the most highly innovative of all economic interactions. However, the worldwide financial crisis of 2008 and the ensuing new laws regulating financial markets, including in particular the 2010 Dodd Frank Act, have quite justifiably stimulated immense attention among economists, both to identify the causes of fragility in financial institutions, and to better articulate ways to alter the architecture of financial markets so as to improve stability without unduly limiting the benefits of the products and services offered in these markets or restricting innovation. An inherent problem associated with designing new regulations is an absence of evidence regarding the effectiveness of policies that have never been observed. In exactly these circumstances laboratory methods can be extremely useful. This project consists of a series of three experiments with applications to emerging issues in financial market regulation. Each experiment represents a way to gain some insight into potential consequences of alternative policies. Experimental results will usefully allow some insight into potential consequences of alternative policy options.
The first experiment evaluates triggering mechanisms for converting contingent capital bonds into equity. Contingent capital bonds ("CoCo's") have been identified as an important new instrument for promoting the stability of systemically important banks. Critical to the successful implementation of CoCo's is an efficient conversion triggering mechanism. Our experiment focuses on the relative performance of the two leading candidate mechanisms, a fixed price trigger in which conversion occurs automatically after crossing a preannounced price threshold and a discretionary regulator, who also sees price information, but who makes decisions in light of imprecise non-price signals, and also face biased incentives to intervene or not. The second experiment pertains to bank runs. In many instances liquidity suspension rather than deposit insurance is the best (or only) policy tool available for discouraging runs on distressed banks. In such instances, bank regulators are rarely able to simply suspend payments until asset maturation, as would be ideal. Rather, they temporarily suspend liquidity, and then re-set contract terms for remaining depositors. In re-setting contract terms, a banking authority must choose whether to skew the terms of payment toward the interests of ?patient? depositors who maintain their deposits in the bank, or toward ?impatient? depositors with unanticipated liquidity needs. Intimately related to re-contracting conditions are the (de)stabilizing effects of publicizing information about depositor withdrawal behavior. Our experiment interacts re-contracting conditions and information regimes to identify the sort of ex post re-contracting and information scheme most likely to promote stability. The third experiment evaluates a simple model of the interbank loan market. In the 2008 financial crisis interbank markets ?locked up,? despite active central bank intervention, raising questions as to why the market failed and what a central bank can do to improve the functioning of this market in times of stress. We propose a simple experimental implementation of a model by Allen, Carletti and Gale (2009) to both better understand the coordination problem faced by banks in this market and to gain some insight as to when and how persistent central bank intervention may be desirable. This experiment will also serve as a baseline environment for evaluating alternative motivations for liquidity hoarding proposed in recent, more complex models.
