Systemic risk in modern financial systems: analytics and policy design

Abstract

PurposeIn recent years, the financial system has been changing rapidly. At the same time, macroeconomic volatility has fallen in developed countries. The purpose of this paper is to examine how these developments may have affected the nature of systemic crises. The paper also aims to discuss how central banks and other financial regulators might respond to these developments with a clearer, more rigorous, operational framework for their systemic financial stability work.Design/methodology/approachThe paper describes analytical models developed at the Bank of England to assess how recent developments may have affected the probability and potential impact of systemic financial crises. The results from these models help to shape the practical framework for the Bank's financial stability work.FindingsThe models suggest that financial innovation and integration, coupled with greater macroeconomic stability, have served to make systemic crises in developed countries less likely than in the past, but potentially more severe. Implementing a practical framework for financial stability work in response to this raises many formidable challenges.Practical implicationsIf individuals are risk‐averse, the recent change in the profile of crises could lower welfare and would suggest that policymakers should place a higher premium on actions to monitor and mitigate systemic risk. The analysis also highlights the importance of differentiating the probability of risks from their potential impact.Originality/valueThe paper will be of interest to academics interested in systemic risk, central bankers, financial regulators, and financial market participants.