Tackling financial storms with the Bank of England

Institution: University of Bristol Business School.
Leading Academic: Professor Evarist Stoja, Professor of Finance.

Background and purpose

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, such as the Bank of England, tasked with regulating other banks and financial institutions to promote financial stability.

While one of the most extreme, the global financial crisis was far from the only destabilising event for financial markets. A different approach to policy design was long overdue. Professor Evarist Stoja, of the University of Bristol Business School, focuses on the pre-cursors, causes and consequences of financial turbulence in his research. Stoja explains, “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 prestigious Norman-Houblon and George Fellowship. This award provides researchers with the opportunity to work closely with colleagues at the Bank of England on the institution’s most pressing economic and financial issues.

Benefits and impact: protecting the economy from future turbulence

For nine months in 2015, Stoja worked full-time at the Bank of England on a collaborative research project, developing 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. Central banks do not need to intervene in these cases other than perhaps offer reassurance.

• Core volatility describes far more systemic, long-term issues with financial systems and the wider economy. It is these fundamental issues that central banks need to focus their efforts on.

Many banks almost 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 using Stoja’s research findings. This allows them to advise each bank on how much capital they need to set aside to withstand the blow and keeps the banks safer, with obvious advantages for every person who relies on stable banks to look after their savings, provide mortgages and manage investments. It also reduces the risk of a volatile situation spiralling out of control.

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,” confirmed Bank of England Senior Economist, Jeremy Chiu.