Tackling financial storms with the Bank of England
In the aftermath of the global financial crisis, University of Bristol Business School research with the Bank of England developed the understanding of financial turbulence to keep the economy safer from future disasters.
Lessons from the global financial crisis
The global financial crisis of 2007-2009 was the most turbulent event in the history of the world’s financial markets for nearly a century. Unscrupulous borrowing and lending practices by banks in the US sparked a chain reaction of financial fissures across the globe that pushed the world’s banking system to the brink of collapse. Many countries plummeted into deep recession and millions of people were driven into unemployment.
The crisis crystallised the urgent need to better understand financial turbulence. This was especially so for central banks, like the Bank of England, tasked with regulating commercial banks and other financial institutions to promote financial stability.
“Financial institutions and regulators were dangerously unprepared for the global financial crisis,” explains Evarist Stoja, Professor of Finance at the University of Bristol.
“The global economy was so much more complex and interconnected than ever before, no central bank was able to predict or readily mitigate its impact.”
Re-occurring turbulence
While one of the most extreme, the global financial crisis was far from the only unprecedented event in financial markets. “Central banks are confronted with entirely new challenges all the time,” says Stoja of the University of Bristol Business School.
“Whether we’re talking about severe situations, on the scale of the COVID-19 pandemic’s effects and the global financial crisis, or less extreme events, it’s often impossible for central banks to inform their policies and actions through historic precedent because there simply is none.”
A different approach to policy design is needed. Stoja, whose research assesses the pre-cursors, causes and consequences of financial turbulence, continues: “To reduce the chances of a turbulent event happening, or reduce its effects where it does occur, central banks need a broad and deep understanding of the different forms of turbulence and of the factors that lead to turbulence in the first place.”
Joining forces with the Bank of England
The Bank of England is at the forefront of efforts to deepen this understanding. Thanks to his established research reputation, in 2015 the Bank of England granted Stoja the Norman-Houblon and George Fellowship. This highly prestigious award provides tenure at the Bank for researchers who offer valuable perspectives on economics and finance. For nine months in 2015, Stoja took leave from the University and worked full-time at the Bank of England on a collaborative research project that developed new ways of thinking around financial turbulence that have since advanced the Bank’s policies and practices.
When – and when not – to respond to turbulence
Central to Stoja and Bank colleagues’ new insights was the definition of two forms of financial turbulence: transitory volatility and core volatility (discussed in Chiu et al, 2016):
· Transitory volatility refers to short-lived events caused by reactions from ‘jumpy or spooked’ investors. There is no need for central banks to intervene in these cases other than perhaps offer reassurance.
· Core volatility describes far more systemic, long-term issues with financial system and the wider economy. It is these fundamental issues that central banks really need to focus their efforts on.
Brexit turbulence
The two types of turbulence are illustrated well by the economic effects of Brexit. Following the EU referendum in 2016, companies exposed to London real estate struggled when investment funds were frozen amid investors’ concerns that property prices could fall. Some companies only narrowly avoided bankruptcy.
“This was a clear case of transitory volatility caused by short-term jitters among investors,” explains Stoja. “Although it was no doubt very tough on real-estate businesses at the time, once investors had had time to absorb the news, things went back to their previous state.”
A similar story emerged in research conducted by Stoja and Bank of England colleagues (published by the Bank of England, Chiu et al, (2017)). Post-referendum, smaller businesses in the UK were considerably more exposed to financial distress than large businesses, as illustrated by greater volatility in the FTSE250 than the FTSE100.
“It seems the larger companies were protected by their international focus, whereas investors were concerned by the UK focus of smaller companies,” Stoja says. “This was also a situation that resolved itself in the short term and the Bank of England did not need to get involved, other than to provide reassurance.”
In contrast, the UK’s actual exit from the EU in 2020 has led to core volatility. “The environment in which the UK does business with other countries has changed at a fundamental level,” says Stoja.
“It is in situations like these that central banks are well placed to step in and support banks and other institutions through targeted actions and policies.”
Efficient regulation
It is now clear that the Bank of England does not need to intervene in every instance of turbulence. “This would be a waste of time and resources. The Bank can focus its efforts on the issues where it makes a real difference,” says Stoja.
The Bank of England confirms the value of these distinctions. Rohan Churm, Head of the Stress Testing Division says: “These findings have important policy implications. Since core volatility is related to [wider economic] fundamentals and transitory volatility is associated with investor sentiment, policymakers are better served by using core volatility rather than total volatility.”
Protecting the economy from turbulence
Many banks nearly collapsed during the global financial crisis. Some actually did, notably Lehman Brothers in the US and Northern Rock in the UK. To help prevent a repeat threat of financial ruin for UK banks, and the damage that that inflicts upon the economy, the Bank of England now conducts annual stress-testing exercises.
Stress-testing exercises look to the year ahead for threats to banks and the financial system. “Perhaps rising unemployment or a drop in house prices is on the cards,” says Stoja. “The exercises explore what would happen to each major bank in these events.” Based on the results, the Bank of England advises each bank on how much capital they need to set aside to withstand the blow.
“This keeps the banks safer, with obvious benefits for consumers who rely upon stable banks to look after their savings, mortgages and investments, as well as businesses in need of a stable source of credit.”
“It also reduces the risk of a volatile situation spiralling out of control, as they did during the global financial crisis”.
The tools used by the Bank of England to assess the potential impact of these threats, and its interpretation of the results, are informed by Stoja’s research findings on turbulence: “The decomposition of volatility into core and transitory volatility is highly useful and informative to the Bank and has made a material impact regarding annual stress-testing exercises,” confirms Bank of England Senior Economist, Jeremy Chiu.
Mutual benefits
The Fellowship gave Stoja unparalleled opportunities to discuss and develop his ideas around turbulence with Bank of England staff and was key to the success of his research.
“I was sharing an office with my Bank of England colleagues, chatting through research ideas in detail and attending their internal meetings. I was part of the team and really got to understand the Bank’s needs and challenges.”
“Together, we could work out the ‘ingredients’ of turbulence, its origins and drivers, and what the Bank should do about it.”
The collaboration has also been very positive for Stoja: “Through the Fellowship and my ongoing advisory work with the Bank, I’ve learned a huge deal about the inner workings of financial regulation, which has shaped and improved my research and led onto new projects. It’s also great to be able to draw on my work with the Bank when I’m teaching students.”
“I’m delighted that the Bank of England, one of the most important central banks in the world, has been able to use my research findings in their decision-making.”
“Their enriched understanding of financial turbulence – and its thoughtful application – stands to reduce the likelihood of another disaster as grave as the financial crisis happening again, as well as mitigate any fallout which places them in a much better position to deal with turbulence when it does occur.”
Built with Shorthand