We develop a stylized interbank market environment and use it to evaluate with experimental methods the effects of liquidity requirements. Baseline and liquidity-regulated regimes are analyzed in a simple shock environment, which features a single idiosyncratic shock, and in a compound shock environment, in which the idiosyncratic shock is followed by a randomly occurring second-stage shock. Interbank trading of the illiquid asset follows each shock. In the simple shock environment, we find that liquidity regulations reduce the incidence of bankruptcies, but at a large loss of investment efficiency. In the compound shock environment, liquidity regulations not only impose a loss of investment efficiency but also fail to reduce bankruptcies.
This Commentary describes experiments conducted to study alternative designs for a new type of financial security, CoCo bonds, that is being used in some European countries to manage the risk of financial crises. CoCo bonds are bank-issued debt that converts to equity when a trigger is breached. The conversion into equity serves to recapitalize a bank during financial distress, precisely when it is hardest to raise capital. The types of trigger used for all CoCos issued thus far are defined in terms of book capital. The experiments we conducted explore the effects of using triggers that are based on market prices.
