Systemic risk, and how the financial system meets and fails to meet society's objectives
Lead Research Organisation:
London School of Economics and Political Science
Department Name: Financial Markets Group
Abstract
The proposed legacy continuation of the Systemic Risk Centre will build on the successful network it has created - academic researchers, public commentators, policymakers and private sector firms - which has been successful in identifying rising issues in the relationship between the financial system and society at large.
The view of the SRC is that the financial system is an essential part of the modern economy, that it can be very helpful, even necessary, in meeting the expectations of society, but that it can also cause very costly financial crises, leading to undesirable outcomes, such as environment damage. It can also be costly to the financial actors and especially to society at large. Finding the balance between the two has always been a core objective of the SRC. We now face new challenges on the intersection between the financial system and the remainder of the economy and other aspects of human society. The SRC being interdisciplinary, can bring to bear multiple disciplines on these problems, and will continue to work with leading experts in political science, law and computer science in addition to its finance experts in addressing these problems.
The SRC has identified the main links between financial policy-making, private risk taking and financial crises, its original mission, and will now investigate at least three problems that are increasingly pertinent.
The first is the relationship between technology and the financial system. We are now seeing technology, both in financial intermediation, such as the payment system and money, as well as more broadly artificial intelligence (AI) strongly interacting with the financial system. New technologies are being developed to solve problems in finance, while those very same technologies also pose poorly understood risks. Financial regulation and internal practices in private financial institutions will need to respond to those challenges.
The second area is the feedback between environment risk and financial risk. The financial system provides funding for private and public sector firms and other activities that either can have a positive or negative impact on the environment, such as via green and brown investments. Rising environment risk impacts on the financial system both directly via environmental change and damage and indirectly via a repricing of brown and green assets and via regulatory constraints, increasing systemic risk. While the importance of the environment to the financial system is clear, the channels for risk, beyond the most obvious, are poorly understood, and in order for both financial regulations and private sector practices to appropriately meet environmental risks it is necessary to understand those risk channels.
The final area is the global financial network. The global financial system is infinitely complex, where its complexity is amplified by the endogenous reaction of the system to itself and other shocks. The notion of exogenous and endogenous risk, as developed by the SRC are particularly suitable for analysing the global network complexity and the threats and benefits it poses. An important dimension to that is how perceptions of risk and therefore decision-making affected by risk, such as investments, including environmentally related, and how capital flows are impacted on by global perceptions of risk versus those specific to individual countries. One particular market we plan to look at is land and real estate (LRE) which - despite being the largest component of wealth and a major driver of global bank failures - has hitherto been left largely unmodelled. We aim to identify how risk perceptions and the new policies meant to tackle LRE might interact to affect the land and real-estate cycles which are powerful contributors to financial and economic malfunctioning. In doing much of the work in this area, we will use a unique dataset the SRC has access to, provided by our long-standing partnership with S&P Global.
The view of the SRC is that the financial system is an essential part of the modern economy, that it can be very helpful, even necessary, in meeting the expectations of society, but that it can also cause very costly financial crises, leading to undesirable outcomes, such as environment damage. It can also be costly to the financial actors and especially to society at large. Finding the balance between the two has always been a core objective of the SRC. We now face new challenges on the intersection between the financial system and the remainder of the economy and other aspects of human society. The SRC being interdisciplinary, can bring to bear multiple disciplines on these problems, and will continue to work with leading experts in political science, law and computer science in addition to its finance experts in addressing these problems.
The SRC has identified the main links between financial policy-making, private risk taking and financial crises, its original mission, and will now investigate at least three problems that are increasingly pertinent.
The first is the relationship between technology and the financial system. We are now seeing technology, both in financial intermediation, such as the payment system and money, as well as more broadly artificial intelligence (AI) strongly interacting with the financial system. New technologies are being developed to solve problems in finance, while those very same technologies also pose poorly understood risks. Financial regulation and internal practices in private financial institutions will need to respond to those challenges.
The second area is the feedback between environment risk and financial risk. The financial system provides funding for private and public sector firms and other activities that either can have a positive or negative impact on the environment, such as via green and brown investments. Rising environment risk impacts on the financial system both directly via environmental change and damage and indirectly via a repricing of brown and green assets and via regulatory constraints, increasing systemic risk. While the importance of the environment to the financial system is clear, the channels for risk, beyond the most obvious, are poorly understood, and in order for both financial regulations and private sector practices to appropriately meet environmental risks it is necessary to understand those risk channels.
The final area is the global financial network. The global financial system is infinitely complex, where its complexity is amplified by the endogenous reaction of the system to itself and other shocks. The notion of exogenous and endogenous risk, as developed by the SRC are particularly suitable for analysing the global network complexity and the threats and benefits it poses. An important dimension to that is how perceptions of risk and therefore decision-making affected by risk, such as investments, including environmentally related, and how capital flows are impacted on by global perceptions of risk versus those specific to individual countries. One particular market we plan to look at is land and real estate (LRE) which - despite being the largest component of wealth and a major driver of global bank failures - has hitherto been left largely unmodelled. We aim to identify how risk perceptions and the new policies meant to tackle LRE might interact to affect the land and real-estate cycles which are powerful contributors to financial and economic malfunctioning. In doing much of the work in this area, we will use a unique dataset the SRC has access to, provided by our long-standing partnership with S&P Global.