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Systemic Financial Risk

image of Systemic Financial Risk

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.   

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Implications

Future research questions

Our findings to this point imply several immediate messages relevant for a future architecture of the financial world:

  • Global monitoring of leverage levels on the institution level. This could be done by central banks. Data should be made available for research. Without the knowledge of leverage levels at the institution scale, imposing and executing maximum leverage levels is pointless.
  • Monitoring and analysis of lending/borrowing networks, both of major financial players and of governments. It should be known who holds the debt of whom. Without this knowledge imposing maximum leverage levels becomes hard to implement.
  • Imposing maximum leverage levels depending on debt structure, trading strategies and position in lending/borrowing networks. Through this measure, regulators could control levels of extreme risk by limiting leverage. This is by no means a trivial undertaking, and needs to be accompanied by massive future research, concerning implications of this step.

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