Financial contagion and the wealth effect: An experimental study

We design a laboratory experiment to test the importance of wealth as a channel for financial contagion across markets with unrelated fundamentals. In a sequential global game, we analyze the decisions of a group of investors that hold assets in two markets. We consider two treatments that vary the level of diversification of these assets across markets. In both treatments, we find evidence of financial contagion. When investors have completely diversified portfolios, we provide evidence of contagion due to a wealth effect: for certain ranges of fundamentals, we show that a decrease in wealth from the investment in the first market makes withdrawals more likely in the second, thereby increasing the probability of a crisis. When portfolio diversification is small, then social imitation is relevant in explaining contagion.