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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.   

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Summary

This report studied the effects of leverage on systemic stability in a simple agent based model of financial markets. It argues that this approach - unlike traditional approaches to risk management - allows to understand market mechanisms which can lead to large scale draw-downs and crashes. Even though the model is phrased in terms of financial agents acting in the financial markets, the essence of its findings can be transferred to national scales. This becomes especially important because of the active involvement of governments in the financial markets.

English

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