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.   




Leverage on the personal scale, in the financial markets and on a national scale - has contributed much - if not most - to the financial crisis 2008-2010, for scientific literature, see Buchanan (2008), Bouchaud (2008), Buchanan (2009), Farmer and Foley (2009). Leverage is generally referred to as using credit to supplement speculative investments. It is usually used in the context of financial markets, however the concept of leverage covers a range of scales from personal life, such as buying a home on credit, to governments issuing public debt.


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