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

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.