An Experimental Analysis of Contingent Capital with Market-Price Triggers

We report an experiment that evaluates three market-based regimes for triggering the conversion of contingent capital bonds into equity: a "fixedtrigger" regime, where a price threshold triggers mandatory conversion; a "regulator" regime, where regulators make conversion decision...

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Published inJournal of money, credit and banking Vol. 46; no. 5; pp. 999 - 1033
Main Authors DAVIS, DOUGLAS, KORENOK, OLEG, PRESCOTT, EDWARD SIMPSON
Format Journal Article
LanguageEnglish
Published Columbus Blackwell Publishing Ltd 01.08.2014
Wiley Subscription Services
Ohio State University Press
Subjects
Allocative efficiency
Bank capital
bank regulation
Banking regulation
Bonds
C92
Capital
contingent capital
Economic shock
Efficient markets
Equity
Error rates
Experiments
Financial regulation
G14
G28
Market prices
Prediction markets
Prices
Range errors
Regulation
Regulatory agencies
Studies
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Summary:We report an experiment that evaluates three market-based regimes for triggering the conversion of contingent capital bonds into equity: a "fixedtrigger" regime, where a price threshold triggers mandatory conversion; a "regulator" regime, where regulators make conversion decisions based on prices; and a "prediction market" regime, where regulators also observe a market that predicts conversion. Consistent with theory, we observe inefficiencies and conversion errors in the fixed-trigger and regulator regimes. The prediction market somewhat improves the regulator's performance, but inefficiencies and conversion errors persist. The regulator regime has conversion errors over the widest range of shocks.
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The authors thank for their useful comments Vinod Changarath, Asen Ivanov, Edward Millner, Robert Reilly, Zhenyu Wang, an anonymous referee, and participants in seminars at the Federal Reserve Banks of New York and Richmond, the Bank of England, the Department of Finance in the Said School of Business at Oxford University, the Department of Economics at the University of Manchester, the School of Business at Virginia Commonwealth University, and conference participants at the Second LeeX International Conference on Theoretical and Experimental Macroeconomics, the 2011 SAET conference, the 2012 Southern Economics Association Meetings, the 2012 Federal Reserve Bank of Cleveland's Conference on Capital Requirements for Financial Firms, and the 2012 FIRS conference. The usual disclaimer applies. Financial assistance from the National Science Foundation (SES 1024357), the Federal Reserve Bank of Richmond, and the Virginia Commonwealth University Summer Research Grants Program is gratefully acknowledged. The views expressed in this paper do not necessarily reflect those of the Federal Reserve Bank of Richmond or the Federal Reserve System.
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ISSN:0022-2879
1538-4616
DOI:10.1111/jmcb.12132