“Systemic financial risk: agent based models to understand the leverage cycle on national scales and its consequences”

Dr. Stefan Thurner’s report analyses the development, buildup and unfolding of financial market crashes using a dynamic agent based model. The model simulates relevant conditions under which agents behave in financial markets and allows one to see how excessive leverage (the use of credit for speculative investments) is a prime source of vulnerability and can act as the catalyst for a crash. The model demonstrates how crashes result as a consequence of synchronization effects of the different actors in financial markets. The report concludes with recommendations, most notably the need for radical improvements in the transparency of creditordebtor relationships between financial market participants, which would reduce the chance of synchronization. What is at stake in a financial crisis? 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. In this scenario, 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 propserity across the board, but also consumer sentiment and trust in the ability of the system to generate long-term wealth and growth. To do something about crises you need to understand them There is no global consensus on how best to manage or prevent financial crises from happening in the future. Nonetheless, policymakers need to develop strategies that are designed to at least reduce the severity of their impacts. In order to stregthen the financial system, making it more resilient to potential abuses in the future, it is critical that we understand the mechanism by which pervasive practice like