Leverage cycles when banks have a choice

41 Pages Posted: 12 Jul 2021

See all articles by Eva Levelt

Eva Levelt

University of Amsterdam, Faculty of Economics and Business (FEB), Students; University of Amsterdam

Kostas Mavromatis

De Nederlandsche Bank; University of Amsterdam - Faculty of Economics and Business (FEB)

Cars H. Hommes

Government of Canada - Bank of Canada; CeNDEF, Amsterdam School of Economics, University of Amsterdam; Tinbergen Institute

Date Written: June 30, 2021

Abstract

Leveraged investing can aggravate crises when dropping asset prices force sales in falling markets. Leverage control policies introduced to coun- teract this could lead to agents targeting the maximal leverage deemed ‘prudent’ at all times. Aymanns and Farmer (2015) show how, for a Value at Risk type control policy, this ‘leverage targeting’ can not only lead to aggravated crises, but can also trigger the crisis to begin with and cause the boom that follows it. In modelling a whole cycle, however, the assumptions that investors base their demand for risky assets only on their leverage target becomes more dubious. In this paper, we allow our agents to repeatedly choose between a leverage targeting and a (leverage constrained) expected utility optimisation strategy. We find that both strategies persist, and in fact are equally prevalent on average. The endogenous cycles that Aymanns and Farmer (2015) found persist, although their amplitude is reduced. Agents will thus regularly choose to invest up to their leverage constraint, without further consideration of the state of the market, even though this destabilises the market. We find that allowing short-selling for agents using the optimisation strategy does stabilise the market.

Keywords: Leverage, Heuristic Switching Model, Short-selling

JEL Classification: G02, E32, G12

Suggested Citation

Levelt, Eva and Mavromatis, Kostas and Hommes, Cars H., Leverage cycles when banks have a choice (June 30, 2021). Available at SSRN: https://ssrn.com/abstract=3882467 or http://dx.doi.org/10.2139/ssrn.3882467

Eva Levelt (Contact Author)

University of Amsterdam, Faculty of Economics and Business (FEB), Students ( email )

Amsterdam
Netherlands

University of Amsterdam ( email )

Spui 21
Amsterdam, 1018 WB
Netherlands

Kostas Mavromatis

De Nederlandsche Bank ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands

University of Amsterdam - Faculty of Economics and Business (FEB) ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands

Cars H. Hommes

Government of Canada - Bank of Canada ( email )

234 Wellington Street
Ontario, Ottawa K1A 0G9
Canada

CeNDEF, Amsterdam School of Economics, University of Amsterdam ( email )

Roetersstraat 11
Amsterdam, NL-1018WB
Netherlands

HOME PAGE: http://https://www.uva.nl/en/profile/h/o/c.h.hommes/c.h.hommes.html

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

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