Impact case study database

Professor Harris’ research has directly informed Bank of England approaches to understanding future risks of shocks within the UK banking sector. Results obtained from Harris’ analytical framework, described above, have been used to improve the formulation and calibration of the annual stress testing exercise undertaken by the Bank of England. In addition, they have improved macro-economic forecasting for the Monetary Policy Committee, allowing the Bank to better gauge the vulnerability of the UK banking system to possible future shocks, and the channels through which these shocks are transmitted. The analysis has also allowed policy makers at the Bank to evaluate feedback mechanisms, which are believed to play an important role during periods of economic turbulence, thus helping to fine-tune the Bank’s policy decisions.

Improved formulation and calibration of the annual stress-test exercise:

Following a recommendation by the Financial Policy Committee (FPC), the Bank of England initiated a programme of annual stress testing in 2014 in order to assess the capital adequacy of the UK banking sector, and its resilience to a range of possible future shocks. The stress testing exercise involves the formulation of a hypothetical scenario, representing a deterioration in global economic conditions that would adversely affect UK banks and building societies. The results of this scenario are compared with those from a baseline scenario that is based on the Bank of England’s forecasts of future macroeconomic conditions. A key issue that emerged from the early stress tests was the need for a better understanding of the linkages between financial market volatility, market sentiment and the ‘real’ economy. This is cited as “a key area for the Bank in terms of ensuring financial stability and a resilient financial system” by the Head of the Bank of England’s Stress Testing Strategy Division, which is mandated with monitoring systemic risk in the UK financial system [5.1].

This issue was addressed by Professor Harris whilst working on secondment at the Bank of England. Based on his underpinning research [3.1] and working together with Dr Evarist Stoja from the University of Bristol, Dr Jeremy Chiu of the Bank’s Stress Testing Strategy Division and Dr Michael Chin of the Bank’s Macro-Financial Analysis Division, Professor Harris developed an analytical framework, distinguishing between the different effects of core and transient financial volatility on the macroeconomic environment, that has influenced policymaking at senior levels within the Bank.

Professor Harris published his findings in Bank of England Working Papers no. 608 and no. 792 [5.2; 5.3] and produced an associated confidential policy note (drawing out and emphasising policy implications and recommendations) that was circulated to senior management within the Bank, including members of the Monetary Policy Committee and Financial Policy Committee. While the outcomes of these discussions and meetings remain confidential, the Head of the Stress Testing Strategy Division has provided a testimonial that confirms that Professor Harris’s work had “ important policy implications, especially for the Bank's annual stress testing exercise and, more generally, for macro-financial analysis. In particular, 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” [5.1].

The Senior Economist at the Bank’s Stress Testing Strategy Division, and Professor Harris’s co-author, confirms the policy impact of the BoE Working paper [5.2], stating that their findings have been “discussed in important policy-making meetings, with the attendance of the Head of the Research Hub, the Head of Stress Testing Strategy Division, and the Head of the Macro-Finance Analysis Division during the summer of 2016. The responses were immensely positive, and our results were recognized as making a material impact regarding macro-prudential policies and annual stress-testing exercise” [5.4].

Improved macro-economic forecasting for the Monetary Policy Committee and broader aspects of financial stability policy-making:

Professor Harris’ analysis is also directly supporting improved macro-economic forecasting at the Bank. The Senior Economist [5.4], now working in the Forecasting Division at the BoE, and in charge of improving in-house modelling, confirms that the Working Paper findings on financial volatility [5.2] have been used to develop a new macro-economic forecasting model that is being used every quarter by the Monetary Policy Committee to inform its decision-making [5.4].

Professor Harris’ work has clearly made an important contribution to the development of effective stress-testing approaches at the Bank of England, enabling the Bank to refine its response to market volatility and thereby playing a critical role in safeguarding the stability of the UK financial system and the wider economy. The significance of Professor Harris’ impact can be viewed in terms of the importance of stress-testing to the UK economy. On its website [5.5], the Bank of England explains the need to ensure that banks and insurance companies are strong enough to withstand another financial crisis: “Banking stress tests assess how banks can cope with severe economic scenarios. We look at banks’ resilience, making sure they have enough capital to withstand extreme shocks and are able to support the economy.” In its latest Financial Stability Report (FSR), the Bank notes a substantial increase in banks’ resilience since the 2007/8 financial crisis: “The FPC judges that the UK banking system remains resilient to a wide range of possible economic outcomes. It has the capacity to continue to support households and businesses even if outcomes are considerably worse than expected. This reflects the build-up of substantial buffers of capital since the global financial crisis” [5.6].

Within changes to the broader policy landscape, stress tests enable the BoE to refine its response to market volatility and thereby play a critical role in safeguarding the stability of the UK financial system and the wider economy.

In addition, the Senior Economist in the Macroprudential Strategy and Support Division of the BoE, and co-author, said in August 2019, of the Working Paper 792 [5.3], that the study “is important and timely and fills a glaring gap in the literature of particular importance to the bank of England” [5.7]. She describes the impact of the work as providing BoE with an improved understanding of the challenges it faces with its communications such as the FSR, delivering “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” [5.7].

Finally, Professor Harris’ research has also supported the Bank of England’s efforts to engage with the wider public on its policy decisions. The non-confidential aspects of the analysis work formed the basis of an article for ‘Bank Underground’, the Bank of England’s blog [5.8]. The blog serves to demystify the work of the Bank for journalists and the wider public. The analysis was also summarised in the Wall Street Journal [5.9].