financial markets

The main aim of the Brevan Howard Centre’s research agenda will be to analyse the market and other failures that appear to be so prevalent in the financial system and make suggestions for improvements.

Understanding systemic risk will be at the heart of these efforts. The regulatory structure in place before the crisis failed because it was based on an incorrect premise. This was that if individual banks and other institutions and investors were prevented from taking excessive risks, there would be no build-up of risk in the financial system and financial crises would be prevented. This proved to be incorrect because of systemic risk.

Currently, systemic risk is not well understood at all. One possible categorisation involves five elements. These are:

  • Panics 
  • Crises caused by drops in asset prices
  • Contagion
  • Deficiencies in the financial architecture  
  • Foreign exchange mismatches.

The traditional analysis of crises focused on panics. More recently, there has been more analysis of crises caused by drops in asset prices. There are many reasons asset prices can drop: the most important one is a fall in the price of real estate. Banks and other financial institutions are heavily involved in lending to buyers, property developers and others engaged in the industry. When property prices fall, often because of the bursting of a bubble, some or all of these borrowers can default and this can lead to a financial crisis.

There are many other reasons asset prices can fall, including rises in interest rates, sovereign default, mispricing due to limits to arbitrage, the business cycle, mispricing due to “flash crashes”, and political interventions of various kinds. Although there has been progress in understanding many of these causes of financial instability, there remains much to be done. For example, even such basic things as the pricing of real estate are not understood.

Progress has been made in understanding and countering some of the remaining three categories of systemic risk. For example, the implementation of swap facilities by central banks during the most recent crisis prevented a reoccurrence of many of the problems that were at the heart of the 1997 Asian crisis. There has also been some work on designing financial architecture. Relatively little progress has been made on understanding contagion.

There remains much work to be done in many other areas too. For example, the role of the central bank in liquidity provision, and the creation of asset price bubbles through low-interest rates and quantitative easing need to be extensively researched. Civil and criminal penalties on banks and other corporations and their managers that engage in illegal behaviour would seem to have an important role to play but little research on the optimal level of damages and fines has been done. All in all, we will have plenty to do.