Tackling financial storms with the Bank of England

Research and impact by Evarist Stoja

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. 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 banks and other financial institutions to promote financial stability.

While one of the most extreme, the global financial crisis was far from the only unprecedented event in financial markets. A different approach to policy design is needed. Stoja, whose research focuses on the pre-cursors, causes and consequences of financial turbulence, explains that “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.”

In 2015 the Bank of England granted Stoja the Norman-Houblon and George Fellowship. This highly prestigious award provides researchers with the opportunity to work closely with colleagues at the Bank on important economics and finance topics that the Bank of England is most concerned with. For nine months in 2015, Stoja 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.

Central to Stoja and Bank colleagues’ new insights was the definition of two forms of financial turbulence: transitory volatility and core volatility:

-  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.

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 informed by Stoja’s research. This allows them to advise each bank on how much capital they need to set aside to withstand the blow, this keeps banks safer. It also reduces the risk of a volatile situation spiralling out of control.