A Classroom Experiment on Banking

Abstract

This classroom experiment uses double oral auction credit markets to illustrate the role of banks as financial intermediaries. The experiment demonstrates how risk affects market interest rates in the presence of asymmetric information. It provides fodder for a discussion of the moral-hazard problem of deposit insurance and its impact on depositor and bank behavior. The basic experiment can be extended to include the effect of political risk on credit markets. The experiment can be used in principles, intermediate macroeconomics, or money and banking courses with 8–75 students. It takes 50–75 minutes to run, depending on class size, and requires no computers.

Keywords:

• asymmetric information
• bank
• classroom experiment
• double oral auction

JEL codes:

• A22
• A23
• G21

Acknowledgments

This article is based on a paper that was presented at the National Conference on Teaching Economics held at Stanford University on June 1–3, 2011.

This experiment is based on one designed with the help of Judith Brenneke, Cynthia Hill, and Richard Schiming at the 2005 Workshop on Classroom Experiments funded by the National Science Foundation.

Notes

1. Other classroom experiments involving banks include Hester's (1991) computerized simulation of bank portfolio management, Cameron's (1997) and Laury and Holt's (2000) money creation exercises, Hazlett's (2003) federal funds market experiment, and Balkenborg, Kaplan, and Miller's (2011) bank run experiment.

2. In the class with 8 students, there were two banks (represented by 1 student each), two firms and four households. In this case, two banks seemed to generate adequate competition, whereas one bank would not.

3. A fuller version of this article with the complete materials for running the experiment is available from the authors upon request.

4. Note that to a risk-neutral firm, undertaking each of the projects looks equally attractive, because the projects have the same expected return. [The low-risk project's expected return is (0.8)(0.4) + (0.2)(−1), the medium-risk project's expected return is (0.7)(0.6) + (0.3)(−1), and the high-risk project's expected return is (0.5)(1.24) + (0.5)(−1), all of which equal 0.12.] However, a risk-neutral lender would not see these projects as equally attractive. For instance, a risk-neutral lender who was offered the same interest rate for funding a high- or medium-risk project (say, 20%) would find the medium-risk project to be the better deal. With the medium-risk project, the lender has a 7/10 chance of collecting the 20%. With the high-risk project, the lender has only a 5/10 chance of collecting the 20%. In the event of project failure, the lender is equally poorly off with either project; he or she loses everything lent. A risk-neutral lender therefore wants a higher interest rate for the riskier project to offset the lower likelihood of repayment.

5. We assume that the loans a bank makes in this experiment are part of its larger overall operations. So when a bank suffers a loss on a particular loan, we do not assume that loss drives the bank into insolvency. A bank that financed a failed project therefore ends that period assuming it will have to pay back depositors, rather than closing down and having the deposit insurance fund repay its depositors.

6. In the case where a firm's project fails, the firm defaults on the loan because it does not have the funds to make the payment on time. This default (i.e., failure to make timely payment) does not mean the loan obligation is canceled. The firm ends the period still owing the funds. In the real world, the future resolution of this default situation would be a legal issue. However, that resolution is outside the scope of this experiment. Because of the uncertainty of any future repayment, the households and/or banks that lent to this firm end the period by considering the loan a loss.

7. In their laboratory reports, most students described a 35% household-to-firm loan in period 2 as an outlier and omitted it from their calculations. That omission made their calculation of the average rate on household funding of low-risk projects 11% over the course of the three periods. They then reported that, on average, across the three periods, firms with low-, medium-, and high-risk projects paid households 11%, 14%, and 19%, respectively. Students emphasized in their written analyses and in the follow-up discussion their conviction that they had experienced a market where households had some, but not perfect, ability to distinguish the riskiness of projects. They cited two sources of that ability: that firms sometimes told the truth, and that in the cases where a firm had already gotten half of its financing from a bank, households could see the rate the bank had charged. Students also noted that firms did sometimes lie about the riskiness of their projects.

8. Alternatively, limiting the number of presidential candidates to two, the instructor can ask 1 of the students to flip a coin to determine whether Candidate X won the election.