Evolutionary pressure for increasing leverage

Free market advocates often argue that markets are best left to operate in an unfettered manner. In this section we demonstrate that regulation of leverage is desirable from several different points of view. We first show that, under the parameter values investigated here, increased leverage leads to increased returns. There is thus “evolutionary pressure” driving leverage up, meaning that without exogenous regulation fund managers are under pressure to use higher leverage than their competitors. If this process is left unchecked, leverage rises to levels that are bad for everyone. This can lead to an increase in the number of defaults and lowers returns and profits for banks as well as for the funds themselves.