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Early warning radar system of financial meltdowns

Dr Simone Giansante’s analysis is helping to detect instability in financial markets. His research could help countries avoid catastrophic financial events.

A computer screen with graphs showing the rise and fall of stocks
Banks across the world are connected through a complicated web of contracts

The global financial crisis of 2007/8 devastated the world’s banking systems. It resulted in several years of recession, and its impact on the world’s political and social landscape is still being felt.

It highlighted the regulatory deficiencies in the sector, which had allowed banks to take excessive risks.

The crisis also revealed the importance of the interconnectedness of financial institutions. Though subsequent analysis deemed this a key factor in the crash, it was not well understood beforehand.

Domino effect

Dr Simone Giansante’s research aims to prevent such a crash from happening again.

Simone and colleagues developed a ‘bank interconnectedness framework’. This enables better risk assessment within the global financial system by identifying ‘systemically important financial institutions’ (SIFIs) and how they are linked.

Banks can be connected either directly or indirectly. Direct connectedness refers to transactions such as lending between the banks. Indirect connectedness relates to things like financial assets: if one bank is forced to sell a large number of financial assets in a short period, then the value of these assets will drop, and any bank with related assets will suffer.

In this way, one institution failing can have a catastrophic impact on the whole financial sector, as the repercussions ripple out through connected banks.

Simone’s interconnectedness model helps banks avoid these situations. By examining the data collected from financial institutions, this ‘early warning system’ shows which banks are contributing most to instability (SIFIs). His model also provides solutions to problems before they cause a meltdown.

A new way to manage risk

Simone’s research has already informed policy changes in central banks and regulatory institutions across the world.

The Reserve Bank of India (RBI) has used the framework to develop software to monitor and manage systemic risk in India’s financial system. This software allowed RBI to adopt processes that supported its financial stability strategy.

As well as RBI, Simone and colleagues were commissioned to help Banque de France, Bank of Finland, as well as supporting research at Banca d’Italia, Banco de Mexico and the European Central Bank.

The benefits of collaboration

The research behind the interconnectedness framework began through a collaboration between the University of Essex and the University of Bath.

After the financial crisis, Simone and colleagues came together to develop a policy response to an issue now known as ‘macroprudential regulation’. This is a type of financial regulation that aims to mitigate risk in the financial system as a whole, rather than on an individual institutional basis.

A key insight from the research was the need for central banks and financial regulators to collect detailed data on bilateral contracts among financial institutions. This data allowed Simone and colleagues to assess the extent of interconnectedness and its potential contribution to systemic risk.

Simone and colleagues presented the research at the 2009 European Central Bank conference and at a special session of an International Monetary Fund meeting. After their success at the IMF meeting, RBI approached Simone and colleagues for help. This in turn led to interest from European banks and financial institutions.

Averting future crises

The financial sector is built on risk. So, while another crisis is always possible, being able to measure and manage the level of risk is key to preventing it.

For this to be truly effective, however, it must be adopted within the financial network as a whole. For this reason, Simone’s aims to disseminate his research as widely as possible.

Since his models were acknowledged by the IMF’s auditing and advice to central banks, he’s well on his way to achieving his goal. Now, Simone and colleagues will continue to work with central banks worldwide to shore up their defences. If financial catastrophe looms again, the world's banks might be better prepared to avoid it.

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