Capital Requirements and Financial Stability: Experimental Evidence

This project was part of the team project "Social Finance – Finance and the Consumer".

Topic and Objectives

In this paper, we further explore the relationship between leverage and bubbles in an asset market experiment. We consider two channels through which higher leverage may produce larger bubbles. First, higher leverage limits downside risk in case of limited liability, which should increase the willing to pay for assets and fuel bubbles (the moral hazard channel). Second, higher leverage may be associated with higher aggregate liquidity, which may also increase the demand for assets and exert upward pressure on prices (the liquidity channel).

We first test the moral hazard channel by conducting an asset market experiment in which traders have to repay debt at the end of the experiment and in which aggregate liquidity stays constant. By varying the level of debt, we can then investigate whether leverage has an impact on trader behavior and asset price bubbles. We then test the liquidity channel by studying a setup in which we inject or withdraw liquidity in the economy to maintain leverage constant over time.