Information Gathering in Government Bailout Decision: An Experiment Ayung Tseng December 8,

Motivation Senator Jim Bunning “…you have decided that just about every large bank, investment bank, insurance company, and even some industrial companies are too big to fail. Rather than making management, shareholders, and debt holders feel the consequences of their risk-taking, you bailed them out. In short, you are the definition of moral hazard.” Senator Judd Gregg “If you hadn't been there, and hadn't been willing to take extraordinary action last fall, last winter, and even early spring … it's very likely we would be experiencing a depression, or certainly a recession that would be radically more severe than what we experienced…” The Federal Reserve held an emergency meeting during the weekend of Sept , 2008, with top Washington policymakers and executives of major financial institutions to discuss the future of Lehman Brothers. Then on Sept 15, Lehmann filed bankruptcy. 2

Research Question What information gathering regime will enable government to receive the most complete and accurate information within a short period of time? This paper uses a laboratory experiment to explore ways of gathering information in government bailout decision during times of crises, especially focusing on the recent financial crisis in the banking industry. The main treatment in this experiment is differentiated by ways of information gathering: mandatory, voluntary, and communicative disclosure. 3

Asset Market Realized return R X (exogenous) Money Market Interest rate R f (exogenous) ConsumersBanks Government Money Supply Investment Set R f rate Lending at R f Deposit at R f Consumer Loan R f + 5% Leveraged 250% Leveraged 180% 10% Deposit 90% Asset 50% Deposit 50% Asset 100% Deposit Risk Averse Capital Ratio Initial endowment (exogenous) Participation in Interbank Market Interbank Market R f Investment Financing Leveraged Size Deposits and Loans distributed by leveraged size Simulation of Financial Crisis

T1 Base year R f = 3.0% T2 R X = (-50%) R f = 0.1% T3 R X = (-20%) R f = 0.1% T4 R X = 10% R f = 0.1% Asset market value $2,032 Money Supply $1,436 Consumer market value $950 Consumer avg. leverage 1.9 Banking industry value $1,925 Banking avg. leverage 19.3 Asset market value $1,016 Money Supply $749 Consumer market total assets $363 Consumers face margin calls and liquidate assets Banking industry value $1,139 Some banks claim bankrupt and default on debts and deposits Asset market value $812 Money Supply $384 Consumer market total assets $23 Consumers default on loans and claim bankrupt Banking industry value $641 More banks claim bankrupt and default on debts and deposits Asset market value $894 Money Supply $445 Consumer market total assets $96 Consumer market starts recovery Banking industry value $631 Banking industry is still affected from interbank debt defaults Simulation Results The simulation shows the consequences of no bailout action and identifies the characteristics of the optimal bailout decision.

Experimental Design Information structure: Aggregate economy loss: Public information Pre-crisis market composition: Public information Post-crisis loss distribution: Private information Main treatments: Period 1-2: Mandatory disclosure without reputation effects Period 3-4: Voluntary then mandatory disclosure Period 5-6: Voluntary then communicative disclosure Period 7-8: Mandatory disclosure with reputation effects 6

Experimental Design (Cont.) Conflicts of Interests: Government: minimize the social impact of financial crisis Banks: maximize shareholders’ value Government bailout decision rule: If the sum of total loss claims submitted by all banks exceeds 120% of the economy’s total loss, no bailout funds are distributed. If the sum of total loss claims is less than or equal to 120% of the economy’s total loss, the government will allocate funds to the bank that reports the largest loss amount first, followed by the second largest, and so on until the bailout fund is exhausted. 7

Experiment Results Mandatory disclosure without reputation effects has the highest chance achieving the optimal decision. In the voluntary disclosure regime, banks’ revised disclosure amount is usually higher than its voluntary disclosure amount. A Pareto-suboptimal equilibrium leads to no bailout funds distributed. The communicative or collusive disclosure achieved an equal distribution of resources, deviated from the government goal of identifying the largest troubled bank. Mandatory disclosure with reputation effects is less effective than without reputation effects. 8

Country 1 Bailout Decision 9

Country 1 Disclosure Amount 10

Country 2 Bailout Decision 11

Country 2 Disclosure Amount 12

Country 3 Bailout Decision 13

Country 3 Disclosure Amount 14

Country 4 Bailout Decision 15

Country 4 Disclosure Amount 16

Conclusion and Improvement During a crisis, moral hazard becomes an issue in information gathering process. This experiment found that the most effective and efficient way to gather information in such a time- constrained situation was mandatory anonymous disclosure. Based on this experiment result, the mandatory anonymous disclosure has a 50% chance leading to the optimal bailout decision. Potential improvement: 1) control six participants in each country, 2) give bank’s endowment in dollar amount, 3) revise the bankruptcy protection rule, 4) provide the probability of bankruptcy, 5) run this experiment on computer, 6) design other more effective information gathering regimes. Any ideas or suggestions? 17