Leverage-induced systemic risk under Basle II and other credit risk policies

TL;DR

This paper uses an agent-based model to compare the effects of Basel II and alternative credit policies on systemic risk, revealing that regulation can both mitigate and exacerbate market instability depending on leverage levels.

Contribution

It introduces a simple agent-based model to analyze the systemic risk impacts of Basel II and alternative hedging policies under different leverage scenarios.

Findings

Basel II reduces default risk at low leverage but increases it at high leverage.

Perfect hedge policy stabilizes markets but is preferred only by banks.

Regulation policies can destabilize markets during high leverage periods.

Abstract

We use a simple agent based model of value investors in financial markets to test three credit regulation policies. The first is the unregulated case, which only imposes limits on maximum leverage. The second is Basle II and the third is a hypothetical alternative in which banks perfectly hedge all of their leverage-induced risk with options. When compared to the unregulated case both Basle II and the perfect hedge policy reduce the risk of default when leverage is low but increase it when leverage is high. This is because both regulation policies increase the amount of synchronized buying and selling needed to achieve deleveraging, which can destabilize the market. None of these policies are optimal for everyone: Risk neutral investors prefer the unregulated case with low maximum leverage, banks prefer the perfect hedge policy, and fund managers prefer the unregulated case with high maximum leverage. No one prefers Basle II.