VCU news

By Leila Ugincius

Two professors in the Virginia Commonwealth University School of Business have been awarded a three-year National Science Foundation grant of $134,768 for a series of financial market experiments.

Economics professors Douglas Davis, Ph.D., and Robert Reilly, Ph.D., have designed 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 policy options.

Financial products and the markets in which they are traded have long been among the most highly innovative of all economic interactions. An inherent problem with creating regulations is the absence of evidence regarding the effectiveness of policies that have never been observed. In these circumstances, laboratory methods can be extremely useful.

“Immense financial incentives, combined with the internationalization of financial trading, deregulation — prior to the last recession — and technological improvements have led to an explosion in financial products and services in the last decades,” Davis said. “These products and services are not always exactly what they seem, and their exchange can importantly affect the stability of corporations, banks and even entire economies.

“An important consequence of the last recession is that regulators have had to think hard about ways to improve stability without undermining the benefits of innovation. Our project uses experiments to assess the relative effectiveness of alternative regulatory approaches.”

The first of the three experiments extends work that Davis conducted with Edward Prescott at the Federal Reserve Bank of Richmond and fellow VCU professor Oleg Korenok regarding triggering mechanisms for a new class of “contingent capital” bonds that regulators are proposing to improve bank stability.

When banks are in trouble, these bonds convert into ownership shares such as stock that usefully retires the banks’ bond obligations. The research focus of this experiment is on the rule that should be used to trigger the conversion.

“Leading candidate rules are either a predetermined fixed rule, such as passing a lower threshold on bank stock prices, or a regulator who has some discretionary authority,” Davis said. “Neither rule is perfect and our experiment will explore some factors that would help distinguish between them.”

The second project considers financial fragility or bank runs.

“The image most people have in their minds about bank runs is George Bailey [James Stewart’s character in “It’s a Wonderful Life”] handing out money for this beloved trip to Europe in order to keep the Bailey Building and Loan from failing in the Great Depression,” Davis said. “The popular view is that this problem was fixed in the aftermath of the Depression. This view is, however, mistaken, as highlighted by the failures of banks and bank-like institutions around the world in the 2008 recession. … For example, does public information about withdrawal activity encourage or discourage stability? Our experiment will look at these issues from a behavioral perspective.”

The third project looks at the behavior of the “interbank loan” market, the market where banks buy and sell liquidity to meet regulatory requirements and, ultimately, depositors’ withdrawal needs. During the 2008 recession the interbank loan market locked up for an extended period of time, Davis said.

“Surprisingly little is known about this very basic market,” he said. “Our experiment examines the usefulness of some possible tools for eliminating ‘liquidity hoarding’ in a simple model of this market.”

This last experiment will be more exploratory than the first two.

“Both [Davis and Reilly] have a long and distinguished research record,” said Carol A. Scotese, Ph.D., chair of the VCU Department of Economics. “This project will apply their considerable expertise to regulation in the financial markets.”

Davis and Reilly hope their experiments will expand the understanding of financial product markets and help identify the types of regulation that will improve stability without hindering innovation.

“The process of scientific research is the slow accretion of information about specific questions,” Davis said. “For that reason we would be foolish to be so brash as to suggest that we can develop definitive policy advice. Nevertheless the questions we explore are policy relevant. For example we hope to provide some useful information regarding when a regulator with discretionary authority may be preferable to a fixed trigger. Again, we hope to be able to improve understanding of conditions under which information regarding withdrawal activity contributes to bank stability.”

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