The dynamics of the leverage cycle

DOI10.1016/J.JEDC.2014.09.015zbMATH Open1402.91901arXiv1407.5305OpenAlexW3124396300MaRDI QIDQ1623972FDOQ1623972

J. Doyne Farmer, Christoph Aymanns

Publication date: 15 November 2018

Published in: Journal of Economic Dynamics and Control (Search for Journal in Brave)

Abstract: We present a simple agent-based model of a financial system composed of leveraged investors such as banks that invest in stocks and manage their risk using a Value-at-Risk constraint, based on historical observations of asset prices. The Value-at-Risk constraint implies that when perceived risk is low, leverage is high and vice versa, a phenomenon that has been dubbed pro-cyclical leverage. We show that this leads to endogenous irregular oscillations, in which gradual increases in stock prices and leverage are followed by drastic market collapses, i.e. a leverage cycle. This phenomenon is studied using simplified models that give a deeper understanding of the dynamics and the nature of the feedback loops and instabilities underlying the leverage cycle. We introduce a flexible leverage regulation policy in which it is possible to continuously tune from pro-cyclical to countercyclical leverage. When the policy is sufficiently countercyclical and bank risk is sufficiently low the endogenous oscillation disappears and prices go to a fixed point. While there is always a leverage ceiling above which the dynamics are unstable, countercyclical leverage can be used to raise the ceiling. We also study the impact on leverage cycles of direct, temporal control of the bank's riskiness via the bank's required Value-at-Risk quantile. Under such a rule the regulator relaxes the Value-at-Risk quantile following a negative stock price shock and tightens it following a positive shock. While such a policy rule can reduce the amplitude of leverage cycles, its effectiveness is highly dependent on the choice of parameters. Finally, we investigate fixed limits on leverage and show how they can control the leverage cycle.

Full work available at URL: https://arxiv.org/abs/1407.5305

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zbMATH Keywords

systemic riskfinancial market simulationleverage cyclespro-cyclical and countercyclical leverage

Mathematics Subject Classification ID

Statistical methods; risk measures (91G70) Financial applications of other theories (91G80)

Cites Work

• Leverage causes fat tails and clustered volatility
• When Micro Prudence Increases Macro Risk: The Destabilizing Effects of Financial Innovation, Leverage, and Diversification
• Market procyclicality and systemic risk

Cited In (11)

• An adaptive dynamical model of default contagion
• When panic makes you blind: a chaotic route to systemic risk
• Impact of value-at-risk models on market stability
• Leverage effect breakdowns and flight from risky assets
• Dynamic Leveraging–Deleveraging Games
• Signal on the Margin: Behavior of Levered Investors and Future Economic Conditions*
• Basel III capital surcharges for G-SIBs are far less effective in managing systemic risk in comparison to network-based, systemic risk-dependent financial transaction taxes
• Analysis of Bank Leverage via Dynamical Systems and Deep Neural Networks
• An agent-based model of corporate bond trading
• Elimination of systemic risk in financial networks by means of a systemic risk transaction tax
• Good speciation and endogenous business cycles in a constraint satisfaction macroeconomic model

Uses Software

• RiskMetrics

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