The dynamics of the leverage cycle

Christoph Aymanns and J. Farmer

Journal of Economic Dynamics and Control, 2015, vol. 50, issue C, 155-179

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 policies 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.

Keywords: Leverage cycles; Pro-cyclical and countercyclical leverage; Systemic risk; Financial market simulation (search for similar items in EconPapers)
JEL-codes: G01 G11 G17 G20 (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (39)

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Working Paper: The dynamics of the leverage cycle (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:50:y:2015:i:c:p:155-179

DOI: 10.1016/j.jedc.2014.09.015

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