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.
Table of contents:
Executive summary Chapter 1. Introduction -1.1 What is leverage? -1.2 The danger of leverage -1.3 Scales of leverage in the financial industry -1.4 Scales of leverage on national levels -1.5 Failure of economics and the necessity of agent based models -1.6 Secondary impacts and the global context -References Chapter 2.A simple agent based model of financial markets -2.1 Overview -2.2 The specific model economy -2.3 Variables in the agent based model -2.4 Price formation -2.5 Uninformed investors (noise traders) -2.6 Informed investors (hedge funds) -2.7 Investors to investment fund -2.8 Setting maximum leverage -2.9 Banks extending leverage to funds -2.10 Defaults -2.11 Return to hedge fund investors -2.12 Simulation procedure -2.13 Summary of parameters and their default values -2.14 An “ecology” of financial agents -2.15 Generic results -References Chapter 3.Evolutionary pressure for increasing leverage -3.1 A demonstration of how markets push for high leverage Chapter 4.How leverage increases volatility -4.1 The danger of pro-cyclicality through prudence -4.2 The process of de-leveraging -References Chapter 5.Leverage and systemic risk: What have we learned? -5.1 Triggers for systemic failure -5.2 Counter intuitive effects -References Chapter 6. Implications: Future research questions -6.1 The need for global leverage monitoring -6.2 The need for understanding network effects in financial markets -6.3 The need for linking ABMs of financial markets to real economy -6.4 Systemic risk is not priced into margin requirements -6.5 Extensions to leverage on national levels -6.6 Data for leverage-based systemic risk on national scales -References Chapter 7. Outlook: Transparency for a new generation of risk control -7.1 Breaking the spell: need for radical transparency -7.2 Self-regulation through transparency: an alternative regulation scheme -7.3 Toward a “National Institute of Finance” -References Chapter 8. Summary -A.1 Pathways toward social unrest: Linking financial crisis and social unrest through agent based frameworks -A.2 Pathways to social unrest not directly related to financial crisis -References