Systemic Financial Risk

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This report analyses the results of simulations using an agent based model of financial markets to show how excessive levels of leverage in financial markets can lead to a systemic crash.  Investors overload on risky assets betting more than they have to gamble creating a tremendous level of vulnerability in the system as a whole.  Plummeting asset prices render banks unable or unwilling to provide credit as they fear they might be unable to cover their own liabilities due to potential loan defaults.  Whether an overleveraged borrower is a sovereign nation or major financial institution, recent history illustrates how defaults carry the risk of contagion in a globally interconnected economy. The resulting slowdown of investment in the real economy impacts actors at all levels, from small businesses to homebuyers. Bankruptcies lead to job losses and a drop in aggregate demand, leading to more businesses and individuals being unable to repay their loans, reinforcing a downward spiral that can trigger a recession, depression or bring about stagflation in the real economy. This can have a devastating impact not only on economic prosperity across the board, but also consumer sentiment and trust in the ability of the system to generate long-term wealth and growth.   


Evolutionary pressure for increasing leverage

Free market advocates often argue that markets are best left to operate in an unfettered manner. In this section we demonstrate that regulation of leverage is desirable from several different points of view. We first show that, under the parameter values investigated here, increased leverage leads to increased returns. There is thus “evolutionary pressure” driving leverage up, meaning that without exogenous regulation fund managers are under pressure to use higher leverage than their competitors. If this process is left unchecked, leverage rises to levels that are bad for everyone. This can lead to an increase in the number of defaults and lowers returns and profits for banks as well as for the funds themselves.


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