Financial contagion, investors' behaviour, and the wealth channel: An experimental study

How do financial crises spread across countries or markets? In today's globalized markets, crises can spread from one country to another even when they have no strong economic links. There is wide consensus that financial interdependencies played an important role in propagating both the 1997 Asian crisis and 2008 Global financial crisis. However, the precise channels through which financial links propagate such crises are less well understood. We propose a laboratory experiment that analyzes the importance of a wealth channel. Specifically, when a pool of risk-averse investors holds investments in two countries, a crisis in one reduces their wealth, making them less willing to take risks and more likely to withdraw their investment in the second country. This increases the probability that a crisis occurs in the second country, even if fundamentals of the two countries are unrelated. However, real-market evidence of this mechanism is limited, since it is often difficult to isolate the wealth channel from other types of investor behaviour. Our experiment will contribute to deepening our understanding of the importance of investors' risk aversion and portfolio diversification in the contagion of financial crises, where the wealth channel can be isolated. The experiment consists of two treatments using a between-subject design. In the first treatment, investors have completely diversified portfolios across two markets, while in the second treatment, investors have investments in only one of the two markets. The wealth channel will be present if withdrawals in the first market increase the likelihood of withdrawals of investments in the second market.

How do financial crises spread across countries or markets? In today's globalized markets, crises can spread from one country to another even when they have no strong economic links. There is wide consensus that financial interdependencies played an important role in propagating both the 1997 Asian crisis and 2008 Global financial crisis. However, the precise channels through which financial links propagate such crises are less well understood. We propose a laboratory experiment that analyzes the importance of a wealth channel. Specifically, when a pool of risk-averse investors holds investments in two countries, a crisis in one reduces their wealth, making them less willing to take risks and more likely to withdraw their investment in the second country. This increases the probability that a crisis occurs in the second country, even if fundamentals of the two countries are unrelated. However, real-market evidence of this mechanism is limited, since it is often difficult to isolate the wealth channel from other types of investor behaviour. Our experiment will contribute to deepening our understanding of the importance of investors' risk aversion and portfolio diversification in the contagion of financial crises, where the wealth channel can be isolated. The experiment consists of two treatments using a between-subject design. In the first treatment, investors have completely diversified portfolios across two markets, while in the second treatment, investors have investments in only one of the two markets. The wealth channel will be present if withdrawals in the first market increase the likelihood of withdrawals of investments in the second market.