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

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 low or 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.