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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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Leverage and systemic risk

What have we learned?

Here follows a summary of the most important findings of the presented agent based model of the financial market (Thurner, Farmer and Geanakoplos, 2010). This report showed qualitatively how different market participants such as informed investors, noise traders, leverage providers, and investors perform their roles in their co-evolving environments. It demonstrates how their performance influences actions of others, and study the effects on e.g. the formation of asset prices. Among many other features, these mutual influences cause price fluctuations and volatility patterns which are observed in real markets.

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