For Farmer, the upshot is that policymakers need to develop
tests that capture the panoply of losses that financial firms face.
In an April paper, Farmer and Alissa Kleinnijenhuis, a graduate
student at Oxford, describe a preliminary model they created of
a systemwide stress test for the European financial system. It
reveals that financial losses from shocks could be three times greater
compared with a traditional stress test and that current capital
buffers may be too small.
“From the research, we can say unambiguously that there
is some amplification of losses from shocks, and I would be very
surprised if the amplification isn’t very significant, particularly
in times of distress,” Farmer says. “So there is a serious problem
to worry about.”
While regulators are far from creating a comprehensive
testing model, the BOE is already moving down this path. It’s
incorporating feedback loops in areas such as counterparty risk
and asset fire sales into its stress tests, said a group of three BOE
researchers—Marco Bardoscia, Marc Hinterschweiger, and Arzu
Uluc—in an email to Bloomberg Markets. Germany’s central bank
has built models to assess the magnification of losses from contagion
and is now discussing whether to include them in stress tests.FARMER, WHO GREW UP in the wide-open desert terrain of New
Mexico, is fond of chasing big, original ideas. “It’s part of being a
scientist to do things that are novel and important,” says Farmer,
who likes to explore the mountains of his home state with a back-
pack and a tent.
He leaped into uncharted territory in the 1970s, whenhad to collect to understand what just happened and how to modify
the models to provide a better narrative.”
Central banks are turning to agent-based models to exploit
the wave of new business and social data sets. One of the most
data-rich models was built by Farmer and a team including Robert
Axtell of George Mason University in Fairfax, Va. They used data
from the U.S. Census Bureau, Internal Revenue Service, housing
sales, and mortgages to set the behavioral rules for buyers and
sellers in the Washington, D.C., housing market from 1997 to 2009.
The research, which showed that mortgage lending policy was the
key driver of the housing bubble, helped establish agent-based
models as an asset for central banks.
Bank of England researchers adapted the Washington model
to the U.K. housing market and found that an increase in the size
of the “buy-to-let” rental sector could boost the volatility of house
prices. Central banks in Hungary and Denmark recently published
papers based on the U.K. model.
In 2018, Grzegorz Halaj was a financial stability specialist
at the ECB when he used an agent-based model to study liquidity
shocks. He tapped balance sheet data for 130 of the largest banking
groups in the European Union and aggregated public figures for
asset managers. In the simulation, after lenders suffer a drain on
deposits, those without an adequate capital cushion cut their
interbank lending. In some cases they also dump assets at fire-sale
prices. The price drop spills over to fund managers holding the
same assets, who then suffer client redemptions and are forced
to sell more. That further depresses prices and amplifies the banks’
losses—in some cases possibly leading to defaults, according to
the ECB working paper by Halaj, now a principal researcher in
the financial stability department at the Bank of Canada.
“It’s part of being a scientist to do things that are
novel and important”VOLUME 28 / ISSUE 5 65