LSE research on systemic risk and contagion in financial markets has informed policymaking at the Bank of England, improving financial stability in the UK.
What was the problem?
To maintain financial stability within one country and globally, major banks and building societies must be able to withstand severe financial shocks without collapsing. If one or more banks default on their payment obligations, losses may spread through the financial system and cause other banks to default.
The banking failures that led to the 2007 to 2009 Global Financial Crisis exposed the fault lines of existing risk management practice and demonstrated the vital importance of spillover and feedback effects – both between financial institutions and between the financial sector and the real economy – to quantifying likely system-wide impacts of financial stresses.
Since then, national banks and regulatory authorities, including the Bank of England, have increasingly used stress-testing exercises to analyse the resilience of an institution or system under a set of extreme, adverse scenarios, such as a national or global recession. Stress tests are used both to measure risks and to manage risk by informing policymaking to regulate banks and the amount of capital they are required to hold.
In 2015, the Bank of England identified the modelling of system-wide dynamics and feedback mechanisms as a priority for its annual stress-testing programme.
What did we do?
Professor Veraart’s research focuses on the use of network models to assess systemic risk and financial stability. In 2013, she and her co-author, Professor L C G Rogers (University of Cambridge), created a model of interbank obligations, given the risk that if one bank defaults on their payment obligations, it cannot call in its loans at full value, and losses can then spread throughout a network causing other banks to default. Their model allows users to compute how much each bank would be able to pay at the end of such a default cascade, and the risk of multiple bank failures.
This model is distinctive in allowing for the addition of default costs. This immediately introduces novel and realistic effects, since these additional costs significantly change the default cascade. Without them, the network spreads losses, but cannot amplify them. If you factor in default costs, however, the initial losses causing an institution to default can be substantially amplified while the default flows in a domino effect through the banking system.
Because these amplification effects are a key concern for policymakers, it is important they are captured in the models used in stress tests. In a paper on distress and default contagion in financial networks, Veraart generalised the framework to allow for financial contagion to be triggered, not necessarily by the default of an institution alone, but also by mark-to-market effects before default, in a scenario of distress contagion. The paper further illustrated how the framework could, in principle, also be applied even if only partial information is available about the underlying network of exposures.
What happened?
Veraart has worked regularly with the Bank of England on developing and using stress-testing models to apply to the UK banking system to simulate what would happen under various scenarios of financial distress. From October to December 2016, she served as a Bank of England George Fellow, based full-time in the Stress Testing Strategy Division of the Financial Stability Strategy and Risk Directorate. Her research was used by the Bank to conduct its annual stress testing in 2016 and 2017, covering seven major UK banks and building societies, which together account for around 80 per cent of banks’ lending to the UK economy.
In 2016, the Bank’s stress test included, for the first time, testing of solvency contagion via interbank lending. This examines how deteriorating capital positions lead to revaluation of interbank debt claims, which can in turn further affect banks’ capital positions. This built on the modelling framework set out by Rogers and Veraart in 2013. The Bank’s Executive Director of Financial Stability Strategy and Risk noted:
“[Veraart’s] research has informed the Bank’s modelling and analysis, in particular on incorporating feedback and amplification mechanisms in the Bank of England annual cyclical scenario (ACS) stress test. Solvency contagion was the first amplification mechanism included in the Bank of England’s stress test in 2016.”
The Bank’s stress-testing programme is a crucial part of its statutory responsibilities to maintain the stability of the country’s financial system. Its purpose is to ensure banking institutions have enough capital to withstand major financial stresses, such as a deep recession. The results of the stress-testing exercise are therefore used to set regulatory capital buffers and to determine whether banks need to improve their capital positions.
Veraart has worked with the Bank on developing further models for testing system-wide stress. This research has analysed liquidity stress in the repurchase agreement (repo) market, looking at the wider financial system beyond the banking sector. More recently, this work has focused on liquidity stress during the early phase of the COVID-19 pandemic.
In 2019, Veraart was recognised for her work on systematic banking risk as co-winner of the University of Cambridge Adams Prize awarded to UK-based researchers under the age of 40 conducting first-class international research in the mathematical sciences.