The Agent Rationality in the Doom Loop of Sovereign Debt: An Agent-Based Model Simulation of Systemic Risk Emergence Process

This article explores the financial systemic risk emergence process using an agent-based simulation model representing the investor attitudes towards risk. The multidisciplinary theoretic base is compound of portfolio selection, sovereign debt securities and agent rationality literature. Following the 2007/8 world financial crisis, the sovereign debt crises in the European countries have been attracting researches, showing a “diabolic loop” between sovereign debt and the banking credit risk fragility, which can be followed by systemic crises. Modern financial systems rely heavily, mainly at times of political-economic uncertainty, on availability of safe assets (risk-free assets) to choose asset portfolios and also to use them as collateral in markets operations. In order to analyze the relations between financial rationality and investments on bonds of the Brazilian sovereign debt, this article uses a bottom-up approach, based on agent rationality, and simulates portfolio selection by neutrals, risk-seeking and risk-averse investors, all of them concrete classes of an investor abstract class. The main findings confirm that rational choices of investments are likely to be at the base of the doom loop that involves sovereign debt and institutional investors. The findings have important implications to policy makers regarding systemic risk issues, among others public policies.