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Research centre to study risks to financial system launched at LSE

A research centre which will study the risks that could trigger the next financial crisis is being launched at the London School of Economics and Political Science (LSE) it was announced today.

The Systemic Risk Centre is being funded by £3,757,475 of government money through the Economic and Social Research Council.

The Centre will undertake an economic analysis of the fundamental risks to the financial system, based on an interdisciplinary approach. It will bring together experts from finance, economics, computer science, political science, law and the natural and mathematical sciences. This will allow researchers affiliated to the Centre to investigate how risk is created through feedback loops within and between the financial, economic, legal and political systems. Political decisions, for example, can directly affect people’s behaviour in the financial markets, which in turn affects political decision making and so on – with the outcomes being unexpected and complex.

The researchers will also examine how the risk of contagion across financial networks can further amplify feedback loops that, in a worst-case scenario, may cause a systemic crisis. This analysis will benefit from the insights brought to the Centre by complex dynamics researchers from the natural and mathematical sciences.

Dr Jean-Pierre Zigrand, co-director of the Centre, said: “When a big crisis happens it’s often not because there is a big external shock to the system but because of how small shocks are amplified through feedback loops within and between systems. We will be trying to understand those loops and networks – who is connected to whom, what does that mean and why.”

The Centre will also analyse how computer-based trading, and high frequency trading in particular, contributes to systemic risk. A partnership with the computer science department at University College London will allow the Centre to run algorithms in a simulated environment. It is hoped this will provide new insights into the risk of algorithms coordinating and feeding back on one another as well as helping to develop smart tools that can help detect problems in real time, such as intelligent circuit breakers.

Dr Jon Danielsson, co-director of the Centre said: “We believe that the same fundamental underlying mechanisms are at work in every crisis, even though the trigger for each is different. There will be another crisis and we won’t be able to predict it because the world is too complex. And it may even be exacerbated by poorly thought out financial regulations which are meant to guard against extreme risk-taking but which may perversely increase its likelihood and severity. However, we hope through our work that we will be able to understand how to build a more resilient financial system and prevent the worst impacts of any eventual crisis.”

Markit, the financial information services company, is the lead data partner to the Centre. Academics will be able to see anonymised information from Markit including quotes and prices of financial products not traded on organised exchanges, such as credit instruments and exotic derivatives. This information will help researchers deduce what the market really thinks, for instance, about the risk of default of a certain entity. This in turn will provide information about new vulnerabilities emerging in the financial system, and systemic risk.

Lance Uggla, CEO of Markit said: “The broad approach adopted by the Centre to understanding the complexities of systemic risk is essential as the world looks to move on from the last financial crisis. The increased understanding this research will provide fits well with Markit’s aim to bring greater transparency to complex financial markets and we are pleased to be able to support this vital project”.

The Centre will benefit from world class experts including Professors Hyun Shin of Princeton University, Douglas Gale of New York University and Guillaume Plantin of Toulouse School of Economics who are all founding partners of the Centre.