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Growth and collapse: An agent-based banking model of endogenous leverage cycles and financial contagion

Growth and collapse: An agent-based banking model of endogenous leverage cycles and financial contagion
Growth and collapse: An agent-based banking model of endogenous leverage cycles and financial contagion
We create an agent-based banking model that allows the simulation
of leverage cycles and financial contagion. Banks within our model adapt their
investment strategies in an evolutionary manner according to the success of their competitors, creating an endogenous interbank loan network and a dynamic asset market as they try to maximise profit by adjusting their leverage. The system exhibits periods of slow risk growth and fast insolvency cascades, allowing us to assess both the size and frequency of those cascades over a long time-frame. We demonstrate that banks endogenise systemic risk into their leverage behaviour when the asset market is subject to either lowor high levels of volatility, but are less successful for medium volatility when the number of bank insolvencies is maximised. We also show that in a low volatility environment, banks are more susceptible to systemic contagion. While the majority of insolvencies occur through the asset side of the balance sheet due to fire sales causing a rapid depreciation in the asset price, failures through the liability side of the balance sheet tend to be correlated, acting as an amplification mechanism to create far more serious cascades. By creating realistic cycles of growth and collapse, the model provides a suitable framework for performing further policy tests.
1757-1170
370-387
De Caux, Robert
a3e6d29e-ed87-4803-b08d-36392c5bf1dd
McGroarty, Frank
693a5396-8e01-4d68-8973-d74184c03072
Brede, Markus
bbd03865-8e0b-4372-b9d7-cd549631f3f7
De Caux, Robert
a3e6d29e-ed87-4803-b08d-36392c5bf1dd
McGroarty, Frank
693a5396-8e01-4d68-8973-d74184c03072
Brede, Markus
bbd03865-8e0b-4372-b9d7-cd549631f3f7

De Caux, Robert, McGroarty, Frank and Brede, Markus (2018) Growth and collapse: An agent-based banking model of endogenous leverage cycles and financial contagion. International Journal of Computational Economics and Econometrics, 8 (3/4), 370-387. (doi:10.1504/IJCEE.2018.096376).

Record type: Article

Abstract

We create an agent-based banking model that allows the simulation
of leverage cycles and financial contagion. Banks within our model adapt their
investment strategies in an evolutionary manner according to the success of their competitors, creating an endogenous interbank loan network and a dynamic asset market as they try to maximise profit by adjusting their leverage. The system exhibits periods of slow risk growth and fast insolvency cascades, allowing us to assess both the size and frequency of those cascades over a long time-frame. We demonstrate that banks endogenise systemic risk into their leverage behaviour when the asset market is subject to either lowor high levels of volatility, but are less successful for medium volatility when the number of bank insolvencies is maximised. We also show that in a low volatility environment, banks are more susceptible to systemic contagion. While the majority of insolvencies occur through the asset side of the balance sheet due to fire sales causing a rapid depreciation in the asset price, failures through the liability side of the balance sheet tend to be correlated, acting as an amplification mechanism to create far more serious cascades. By creating realistic cycles of growth and collapse, the model provides a suitable framework for performing further policy tests.

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More information

Accepted/In Press date: 20 November 2017
e-pub ahead of print date: 25 November 2018
Additional Information: (accepted)

Identifiers

Local EPrints ID: 415960
URI: http://eprints.soton.ac.uk/id/eprint/415960
ISSN: 1757-1170
PURE UUID: 5d0aa36a-97a3-4b69-95f8-ae93e9348bd4
ORCID for Frank McGroarty: ORCID iD orcid.org/0000-0003-2962-0927

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Date deposited: 29 Nov 2017 17:30
Last modified: 07 Oct 2020 06:09

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Contributors

Author: Robert De Caux
Author: Frank McGroarty ORCID iD
Author: Markus Brede

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