Leverage and Systemic Risk

Santa Fe Institute, Santa Fe NM

Investigators

Abstract

The recent global economic crisis illustrates how financial leverage can generate couplings between different sectors of the financial system and how problems in the financial sector can affect the real economy. This research team will develop new types of agent-based quantitative models to enable a deeper understanding of the causes of extreme or systemic risks in the financial system, focusing in particular on the roles of leverage, network structure, and institutional rules. The goals of the project include determining optimal leverage levels; understanding the effects of network structure on systemic risks; predicting default rates; understanding the role of leverage in contagion between assets; understanding the role of time granularity in risk monitoring; finding improved risk control schemes for banks; and exploring intervention policies for preventing financial failure. The Federal Reserve Bank of New York and the Bank of England will provide access to data for model calibration purposes. The models developed should provide guidance about policies that can foster stability in the financial system. Insight into the effects of various leverage levels, repayment schedules with less systemic impact, or a better understanding of the properties of networks of banks and lenders might be helpful in mitigating future financial crises.