Impact case study database

Stoja’s research has advanced the way that the Bank of England understands, models and responds to volatility [3.1; 3.3; 3.5] and extreme events [3.2; 3.4] and how it communicates financial information [3.6]. These benefits to the Bank, translate into benefits for the UK financial markets through effective Bank regulation. These markets are global and anyone who relies on them for savings, mortgages, pensions or investments, stands to benefit from the Bank’s improved response to volatility.

His fellowship and advisory role (2015-onwards) have allowed him access to highly influential stakeholders in the Bank of England. His research findings have been presented to the Board of Governors of the Bank. Stoja’s work was commissioned and presented to the Head of the Research Hub at the Bank, the Head of the Stress Testing Strategy Division, and the Head of the Macro-Finance Analysis Division. It has also been discussed in meetings and presentations involving the Bank’s policymakers who include members of the very influential Monetary Policy Committee and Financial Policy Committee.

Stoja’s work has also reached a broad professional and practitioner audience. Aspects of his work are summarised in Bank of England Policy Blog posts (published 2015-2019) [5.1-5.3]. These led to articles in the eminent Wall Street Journal (2017) [5.4] and Central Banking (2017) [5.5] . Stoja’s research and these professional articles have influenced the planning and policy of the Bank [5.6], leading to three key impacts.

1. When – and when not – to respond to volatility

Stoja’s distinction between fundamental and transitory volatility in financial markets helped to determine that not all volatility in financial markets has consequences. As a result, it is now clearer to the Bank of England that it does not need to intervene in every instance of turbulence.

This new finding is now one of the body of arguments the Bank uses to guide when and how to react to specific types of turbulence and volatility. As an example, in the Bank of England Policy Blog based on one of his internal studies (2017) [5.2], Stoja discusses the clear turbulence and distress caused by Brexit on small and medium-sized companies. However, large companies appeared unaffected. The rationale was that the latter are more insulated due to their international focus whereas the former are more exposed due to their focus mainly on the UK economy. However, the turbulence of the small and medium-sized companies was mainly transitory and the Bank understood that there was no need to intervene, other than to offer reassurance. This avoided unnecessary action on the Bank’s part.

The distinction between fundamental and transitory volatility has also informed the Bank’s own analyses and practices in broader ways. Their Head of the Stress Testing Strategy Division has said of Stoja’s research: “ These findings have important policy implications … since the core volatility is related to macroeconomic fundamentals while transitory volatility is associated with investor sentiment, policy makers are better served by using core volatility rather than total volatility in calibrating the adverse scenarios, especially for the Bank's annual stress testing exercise and, more generally, for macro-financial analysis.” [5.6].

A senior economist at the Bank has further commented: “ the decomposition of volatility into fundamental and transitory volatility is highly useful and informative to the Bank and has enabled researchers and policy-makers to distinguish between the two … very different forms of turbulence... and were recognised as making a material impact regarding macro-prudential policies and annual stress-testing exercise. Moreover … the paper continues to create impact across directorates … the results that volatilities improve the forecasting performance of macroeconomic variables have directly led to the development of a forecasting model… used by the Monetary Policy Committee every quarter” [5.7]. This new forecasting model helps the Bank fulfil its mandate of maintaining price stability through monetary policy measures, the use of which depends on reliable macroeconomic forecasts and timely monitoring of volatility [5.7].

1. Improving the Financial Stability Report for practitioners

The Bank of England has made changes to how it presents its Financial Stability Report in response to Stoja’s finding [text removed for publication] [3.6]. The Report is one of the Bank’s flagship publications. It involves hundreds of analysts and costs hundreds of thousands of pounds to produce. To enhance the Report’s utility and circulation among practitioners, Stoja advised that it should be shorter and written in simpler language. The Bank of England has understood the findings and their implications and has “ engaged extensively with the writers of the Financial Stability Reports, to exchange views and provide input for the future issues" (Senior Economist, Bank of England) [5.8].

Another Senior Economist at the Bank commented: “ these important findings and conclusions were widely distributed inside the BoE during 2018 and 2019. In line with this recommendation, the Bank has recently started to complement its Financial Stability Report with visual summaries to make it more digestible and reach a wider audience … Overall, the impact of this work has been a much improved and deeper understanding of the challenges … that the Bank faces in its … communications and the concrete steps necessary to address those challenges which the Bank has accepted and has started to implement and will continue to do so in the medium to long term…as it pursues its core objective of financial stability and ultimately a healthy British economy." [5.8].

1. Improved models for stress testing and portfolio management

Stoja’s work has contributed to how the Bank builds its models of stress tests and how it interprets the results. Stress tests, conducted every year, are hypothetical scenarios of stress on financial institutions. These could explore, for example, the combined effects of falling house prices, increased unemployment and increases in interest rates; or EU economies doing well but China and the U.S. experiencing a recession. The tests’ results influence capital requirements for financial institutions that do not fare well in the tests. Stoja – together with Bank staff – developed, for the first time [3.5], a “ framework for analysing the dynamic relationships between financial market volatility, macroeconomic fundamentals and investor sentiment … These findings have important policy implications, especially for the Bank’s annual stress testing exercise.” (Head of Stress Testing Division, Bank of England) [5.6].

The Bank’s new Agenda for research [5.10] continues to prioritise a deeper understanding of market stress with three Priority Topics for 2021 in this area: “What features are needed in models that can be used to assess the costs and benefits of prudential policy responses to specific shocks? How can the interactions between the different parts of the financial system and the real economy be modelled to assess the economy’s response to large shocks?” and “ What are the implications of deployment of machine learning and artificial intelligence by firms for the financial system?” with a particular focus on whether AI can be used to game stress tests.

One way that the Bank of England maintained stability during the financial crisis was to buy financial assets. This intervention introduced a large and strong buyer in a market which increased and maintained liquidity, the lifeblood of a well-functioning market. However, the Bank also increased very substantially its balance sheet, the amount of assets that it bought and now holds on its books. These are relatively risky assets designed for profit-seeking investors. Thus, the Bank is currently exploring ways to reduce its balance sheet by selling these assets. For these assets to be offloaded from the Bank’s balance sheet, many financial institutions would need to buy. However, the quantity these financial institutions would buy is uncertain. For this purpose, “ the Bank of England benefited greatly from the Dynamic Black-Litterman model” developed by Stoja in a Bank of England Working Paper, No. 596, published April 2016 [5.9]. This model proposes a general framework for portfolio management that “ better reflects the conditions and developments in the markets” and “is suitable for sophisticated investors and offers a number of advantages over existing models, especially in regard to incorporating extreme events” [5.9]. It benefited the Bank as an “ important part of the plans that were being formulated … as it explored strategies that could eventually be used to reduce [the Bank’s] balance sheet in a way that would be consistent with its policy objectives, including supporting the British economy.” (Former Research Manager, Bank of England) [5.9].