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.
Published on June 26, 2012
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