Experiments in Financial Economics: Volume 16

To provide a selective review of most recent developments in experimental economics of banking and lending and to summarize and synthesize the experiment designs and results in banking under asymmetric information.

The review includes recently published or working papers (2006–2013) that exclusively employ experimental economics methodology, especially for studying the impact of formal or informal institutions on lending in credit markets.

The results of the reviewed experimental studies provide support for the important role of both informal (e.g., relationship banking and reputation) and formal (e.g., third-party enforcement; collateral) institutions and their impact on credit market performance, as well as the importance of studying the interaction of the two types of institutions.

The number of studies reviewed is fairly small but growing, indicating that this is the area of growing significance.

Controlled economic experiments are better able to address the questions regarding the direction of causality in empirical relationships. Economic experiments are particularly useful in studying complex markets like credit and capital and in eliciting specific effects of institutions on credit market performance. Such well-established empirical relationships will be able to provide guidance for policy making for financial market reform.

This is the first review of laboratory research in banking and lending under asymmetric information that aims to call attention to this area of research and serves as a starting point for an interested researcher and provide future direction.

The chapter studies strategic default using an experimental approach.

The experiment considers a stochastic asset process and a loan with no down-payment. The treatments are two asset volatilities (high and low) and the absence and presence of social interactions via a direct effect on the subject's payoff.

I demonstrate that (i) people appear to follow the prediction of the strategic default model quite closely in the high asset volatility treatment, and that (ii) incorporating social interactions delays the strategic default beyond what is considered optimal.

The study tests adequately the strategic default using a novel experimental design and analyzes the neighbor's effect on that decision.

We compare allocation rules in uniform price divisible-good auctions. Theoretically, a “standard allocation rule (STANDARD)” and a “uniform allocation rule (UNIFORM)” admit different types of low-price equilibria, which are eliminated by a “hybrid allocation rule (HYBRID).” We use a controlled laboratory experiment to compare the empirical performances of these allocation rules.

We conduct three-bidder uniform price divisible-good auctions varying the different allocation rules (standard, uniform, or hybrid) and whether or not explicit communication between bidders is allowed. For the case where explicit communication is allowed we also study six-bidder auctions.

We find that prices are similar across allocation rules. Under all three allocation rules, prices are competitive when bidders cannot explicitly communicate. With explicit communication, prices are collusive, and we observe collusive prices even when collusive agreements are broken. Collusive agreements are particularly fragile when the gain from a unilateral deviation is larger, and an implication of this is that collusive agreements are more robust under STANDARD.

We do not find conclusive evidence of differences in performance among allocation rules. However, there is suggestive evidence that STANDARD may be more vulnerable to collusion.

Divisible-good uniform price auctions are used in financial markets, but it is not possible to use naturally occurring data to test how alternatives to the standard format would perform. Using laboratory methods we provide an initial test of alternative allocation rules.

We investigate the implications of the misalignment between manager and shareholder interests and the effects of initial ownership stakes and reinvestment of unpaid dividends on managerial self-dealing.

We collect and analyze data from controlled laboratory experiments with an experimental setting which captures the role of ownership in managerial considerations.

We see the emergence of both investor-aligned outcomes and managerial self-dealing outcomes. We find that increasing managers’ initial endowment of shares makes it harder for managers to coordinate on an outcome and lowers return on investment. Moreover, allowing managers to reinvest unpaid dividends results in a transfer of wealth to management.

The results and the conclusions are drawn upon data from the particular setting we investigate. Generalizing them beyond the specific setting should be done with caution.

Higher managerial ownership stake means that managers have a greater incentive to reward shareholders, but we find that it may also imply a more difficult coordination problem between managers – sometimes to the detriment of shareholders.

This study is the first to consider the direct relationship between managers’ portfolios and voting decisions regarding dividends and investment levels.

Previous studies showed mixed results as to the cause of myopic loss aversion (MLA). This paper reexamines the main driver of MLA, considering two factors from previous studies and an additional factor.

Experimentally investigate whether flexibility of investment, frequency of information feedback, or timing of decision cause MLA.

Timing of decision and flexibility of investment explain most differences in subject behavior. Frequency of information feedback makes only a marginal contribution.

The differences in subject behavior can be interpreted by a shift in their reference points depending on the difference in flexibility of investment, frequency of information feedback, or timing of decision.

This chapter examines the debt aversion of a group of college students who have the opportunity to take out a sizable, low-interest, non-credit dependent loan. If the loan is simply invested in low-risk assets, it would effectively yield a free lunch in net interest earnings.

The research uses survey data to examine demographic, socio-economic, personality traits, and other characteristics of those willing and unwilling to accept the loan offer, as well as their intentions of early repayment.

Individuals willing to accept the loan tend to have prior debt, longer planning horizons, come from middle-income families, and may have higher cognitive ability. Anticipated early repayment of the loan is more likely among those with prior investments, no prior debt, from STEM majors, with upper income parents, and those who expect to buy a home soon.

We find no consistent relationships between debt aversion and intellectual ability or gender, but this finding may be hampered by our small sample of female loan-rejecters. Our limited sample size also precludes examining interactions between the dimensions of personality types.

We suggest consideration of policies to encourage “smart” borrowing, focusing on the financially disadvantaged, particularly for education loans. This study examines a uniquely occurring natural experiment regarding the opportunity to accept a non-credit dependent loan. Our results describe the behavior of young adults, an infrequently studied yet important segment of the population, especially in the context of borrowing behavior.