Dynamic Coordination, Runs, and Efficient Policy Design

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When a firm is in trouble, investors may be able to secure better payoffs if they withdraw investments while the firm is still solvent rather than wait until it is terminated. This higher payoff from a successful exit motivates investors to withdraw early - a phenomenon known as a coordination failure or a "run" - even though the superior outcome for everyone would be for all investors to remain invested. These runs often lead to the inefficient termination of productive firms. The threat of a potential run is so prevalent in many different markets that it has stimulated sustained interest among academics, regulators, and practitioners. Consider the following examples:Example 1 (bank deposits): Depositors may worry that their bank could fail, thereby causing them to lose their deposits. Consequently, depositors may rush to redeem deposits, causing the bank to fail. This phenomenon is referred to as a "bank run."Example 2 (corporate debt): Creditors in distressed companies may have incentives to demand the return of their money over concerns that other creditors are demanding repayment. The sudden demand for repayment from a significant portion of creditors can force productive companies into bankruptcy.Recognizing the significant consequences of potential runs, practitioners and policymakers have developed many policies to foster coordination among investors, for example:Policy 1 (suspension of convertibility): When capital outflows from a bank reach a certain threshold, the bank may suspend convertibility of deposits and distribute the remaining assets among all depositors.Policy 2 (avoidable preference): Repayments made to lenders prior to a company's bankruptcy may be subject to clawback and redistribution among all remaining lenders. Under the avoidable preference legislation in the United Kingdom, the clawback window ranges from six months to two years.The aim of this project is to offer a general framework based on dynamic game theory and analyze the impact of different policies on investors' decisions to run when the firm is still operating. To see why such a systematic investigation is necessary, I sketch an unintended consequence of Policy 2 (repayment clawback). By clawing back more repayments, the remaining lenders receive more in the event of bankruptcy, making bankruptcy less devastating. This channel reduces lenders' incentives to run. Suppose a policymaker would like to keep a firm alive for as long as possible; should the clawback window then be as long as possible? Surprisingly, no! Having a longer clawback window can make creditors more anxious to run because they need to run early enough to ensure that their repayments will fall outside of the clawback window. The firm may fail even sooner. This novel insight allows me to study optimal parameters in these policies, such as the suspension threshold in Policy 1 and the clawback window in Policy 2. Furthermore, based on the analysis of the existing policies, I can propose new policies that could enable better coordination among investors.The project will benefit academics, policymakers, and practitioners. Dynamic coordination games have been difficult to solve traditionally. The general game-theoretic framework developed in this project will be a useful tool to assist future theoretical researchers in studying related problems in many different contexts. The model will also yield many testable implications on investors' behaviour that empirical researchers can verify using economic data. The policy implications from the model will help regulators to design more efficient termination procedures so that coordination failures among investors will be alleviated as much as possible. Practitioners will benefit from a better understanding of the mechanisms driving potential runs among investors, thereby helping them to design contract features that increase coordination among investors and minimize failures of viable businesses.