Centre for Risk Studies

Financial Catastrophe Risk

The objective of our research into financial crises is to fully understand the frequency and severity of extreme tail risk catastrophes and how measures taken by regulators, financial services companies, and other practitioners can manage risk at an individual company level, and for society as a whole. The Centre's research provides coherent structural models of extreme financial crisis scenarios that reflect the systemic dynamics of the interconnected financial system, for practitioners managing tail risk in the financial services and investment industry.

Understanding systemic financial risk

Many businesses, financial institutions, and investors are grappling with improving their understanding of market risk ever since the 2008 financial crash. Our objective is to develop a probabilistic model that describes the full range of potential future financial crises, from the wide range of potential triggers, and incorporating the contagion propagation mechanisms that are likely to result. There are significant methodological challenges in quantifying the likelihood and the consequences of future crises, but major benefits if this can be achieved. Risk managers need to understand financial contagion and the correlations that increase during a financial crisis, to track and monitor systemic risks, to develop contingency plans for their occurrence, and to set aside adequate risk capital and meet regulator and governance requirements for the most extreme events.

Model of the Global Financial System

The Cambridge Model of the Global Financial System provides a framework to explore how the interconnectivity of banks and other institutions provides contagion mechanisms for financial shocks (Interbank lending; fire-sales of commonly-held assets; cross shareholding; rollover risk, etc.).

We plan to develop this for use by practitioners in understanding limits and constraints to the severity of crises, counterparty risk, how resilient the system is as a whole, and how systemic behaviour may change under new conditions, such as regulatory constraints, industry consolidation, or institution behaviour.

Scenario studies and investment portfolio impacts

In 2015 the release of four financial catastrophe stress test scenarios demonstrated a methodology for extrapolating extreme events beyond conventional forecasting limits. This suite provides coherent stress tests of the global financial system of relevance to the investment community, policy makers, and international business. We plan to extend the suite of potential stress test scenarios to address key areas of economic and financial planning concerns, and to develop improved approaches for understanding how likely these are to occur.

Indicators and early warning systems

As part of our financial catastrophe scenario research, we have begun an exploration of historical and theoretical evidence for early warning indicators of financial crises. This work identifies and assesses potential leading indicators of systemic risk and explores the business value of early warning in rebalancing investment portfolios and other risk management measures.

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