Leverage cycles when banks have a choice

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.