Taming the Basel Leverage Cycle

40 Pages Posted: 16 Jul 2015

See all articles by Christoph Aymanns

Christoph Aymanns

London School of Economics & Political Science (LSE) - London School of Economics; University of St. Gallen - School of Finance

Fabio Caccioli

University College London

J. Doyne Farmer

University of Oxford

Vincent Tan

University of Oxford - Oxford-Man Institute of Quantitative Finance

Date Written: July 15, 2015

Abstract

Effective risk control must make a tradeoff between the microprudential risk of exogenous shocks to individual institutions and the macroprudential risks caused by their systemic interactions. We investigate a simple dynamical model for understanding this tradeoff, consisting of a bank with a leverage target and an unleveraged fundamental investor subject to exogenous noise with clustered volatility. The parameter space has three regions: (i) a stable region, where the system always reaches a fixed point equilibrium; (ii) a locally unstable region, characterized by cycles and chaotic behavior; and (iii) a globally unstable region. A crude calibration of parameters to data puts the model in region (ii). In this region there is a slowly building price bubble, resembling a "Great Moderation", followed by a crash, with a period of approximately 10-15 years, which we dub the "Basel leverage cycle". We propose a criterion for rating macroprudential policies based on their ability to minimize risk for a given average leverage. We construct a one parameter family of leverage policies that allows us to vary from the procyclical policies of Basel II or III, in which leverage decreases when volatility increases, to countercyclical policies in which leverage increases when volatility increases. We find the best policy depends critically on three parameters: The average leverage used by the bank; the relative size of the bank and the fundamentalist, and the amplitude of the exogenous noise. Basel II is optimal when the exogenous noise is high, the bank is small and leverage is low; in the opposite limit where the bank is large or leverage is high the optimal policy is closer to constant leverage. We also find that systemic risk can be dramatically decreased by lowering the leverage target adjustment speed of the banks.

Suggested Citation

Aymanns, Christoph and Caccioli, Fabio and Farmer, J. Doyne and Tan, Vincent, Taming the Basel Leverage Cycle (July 15, 2015). Available at SSRN: https://ssrn.com/abstract=2630971 or http://dx.doi.org/10.2139/ssrn.2630971

Christoph Aymanns (Contact Author)

London School of Economics & Political Science (LSE) - London School of Economics ( email )

United Kingdom

University of St. Gallen - School of Finance

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

Fabio Caccioli

University College London ( email )

Gower Street
London, WC1E 6BT
United Kingdom

J. Doyne Farmer

University of Oxford ( email )

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

Vincent Tan

University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )

Eagle House
Walton Well Road
Oxford, Oxfordshire OX2 6ED
United Kingdom

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