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An experimental analysis of contingent capital triggering mechanisms

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  • Douglas Davis
  • Edward Simpson Prescott
  • Oleg Korenok

Abstract

This paper reports an experiment that evaluates three regimes for triggering the conversion of contingent capital bonds into equity: (a) a “regulator” regime, where socially motivated regulators make conversion decisions based on observed prices, (b) a “fixed trigger” regime where a price threshold triggers a mandatory conversion, and (c) a “prediction market” regime where we supplement the regulator’s information set with the results of a prediction market that elicits traders’ perceived likelihood of a conversion. Consistent with theory, we observe informational and allocative inefficiencies as well as numerous errors in conversion decisions in both the regulator and fixed trigger regimes. Contrary to theory, however, we also observe inefficiencies and frequent conversion errors in the prediction market regime. Although the fixed trigger and prediction market regimes are more informationally efficient than the regulator regime, allocative efficiencies remain low and conversion error rates high in all three regimes. ; Earlier title: Market-based corrective actions - an experimental investigation

Suggested Citation

  • Douglas Davis & Edward Simpson Prescott & Oleg Korenok, 2011. "An experimental analysis of contingent capital triggering mechanisms," Working Paper 11-01, Federal Reserve Bank of Richmond.
  • Handle: RePEc:fip:fedrwp:11-01
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    References listed on IDEAS

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    Cited by:

    1. Mark J. Flannery, 2016. "Stabilizing Large Financial Institutions with Contingent Capital Certificates," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 6(02), pages 1-26, June.
    2. Edward Simpson Prescott, 2012. "Contingent capital: the trigger problem," Economic Quarterly, Federal Reserve Bank of Richmond, issue 1Q, pages 33-50.
    3. Murphy, Gareth & Walsh, Mark & Willison, Matthew, 2012. "Financial Stability Paper No 16: Precautionary contingent capital," Bank of England Financial Stability Papers 16, Bank of England.
    4. Berg, Tobias & Kaserer, Christoph, 2015. "Does contingent capital induce excessive risk-taking?," Journal of Financial Intermediation, Elsevier, vol. 24(3), pages 356-385.
    5. repec:fip:fedreq:y:2012:i:1q:p:33-50:n:vol.98no.1 is not listed on IDEAS
    6. repec:wsi:gcrxxx:v:05:y:2015:i:01:n:s2010493615500063 is not listed on IDEAS
    7. Allen, Linda & Tang, Yi, 2016. "What’s the contingency? A proposal for bank contingent capital triggered by systemic risk," Journal of Financial Stability, Elsevier, vol. 26(C), pages 1-14.

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    Keywords

    Financial institutions ; Financial markets;

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