When Eric Finn Schaanning was featured in Spotlight on Young Researchers in 2017, he had just defended his AFR PhD on fire sales and systemic risk in financial networks at Imperial College London. In 2017, Eric attended the Lindau Nobel Laureate Meeting and in 2018, won an FNR Award for his PhD thesis. 5 years after his PhD, we catch up with Eric, who has been working on cyber risks, financial and regulatory stress tests as well operational risk management – a career spanning Norway, Frankfurt and Zürich – and reflect on the value his PhD has added.
The stress test model you developed during your PhD for which you won an FNR Award, has this been more widely implemented to your knowledge, or developed or evolved in some way?
“Beyond the utilisation in the Bank of England’s official stress test of 2017, parts of the model (i.e. the fire sales contagion mechanism) came to use during the COVID crisis at the European Systemic Risk Board and the European Central Bank.
“We used the model to answer the pressing question whether any systemic repercussions should be feared if bonds that were at risk of being downgraded from an “investment grade” class to the “subinvestment grade” class actually got downgraded. To this end, we conducted an analysis combining different scenarios and assumptions regarding how the economy and financial market participants might behave over the summer of 2020.
“We concluded that while the impact could be large in principle, it would not be sufficiently large to cause systemic risk on its own. The analysis was published as a technical note and also later on as a shorter article on VoxEU.
What was your next step after completing your PhD?
“After my defence, I stayed for another year at the Norwegian Central Bank, Norges Bank, who had supported me throughout the PhD with both data and expert judgement to develop and calibrate my models. During this year, I was working on various topics around financial stability such as overseeing the safety and soundness of “central counterparties (CCPs)” – the type of financial market infrastructure through which derivative contracts now need to be cleared after the post-crisis regulatory reforms of 2009.”
What have you been working on in the last 5 years?
“Between 2018 and 2021, I went on a three-year secondment from the Norwegian Central Bank to the European Systemic Risk Board, which is based at the European Central Bank in Frankfurt.
“There, I was coordinating a task force on cyber risks, which culminated in the first “Systemic Cyber Risk” report and tackled the question whether “under the right circumstances” a cyber-attack could evolve into a “classic” financial crisis (i.e. grow past a mere operational problem into a financial stability concern) and we concluded this analysis with a “yes”.
“Moreover, I was also coordinating a task force which designs the adverse scenarios for the largest European regulatory stress tests, such as the EBA EU-wide bank stress test or the European stress tests for insurers and pension funds conducted by EIOPA.
“After the end of my secondment, I decided to move even closer to operational risk management and took up a role at Credit Suisse in Zurich, where I am responsible for the interest rate risk and asset liability management risks of entities in the EMEA region.”
You earned a PhD and then left the world of research for a new adventure. What did you learn during your PhD that you have been able to apply in your professional life?
“While the time spent crunching numbers, solving equations and producing computer code has decreased since my PhD days, I have continuously moved closer to “hands-on” risk management. In my career I’ve benefited from skills such as precision, perseverance and remaining optimistic during long periods of difficult work that I’ve earned during the PhD.
However, I think it’s a “two-way” street of learning: having moved into more operational roles and having thought about the same topic from an academic, a policy making, and now also a private sector perspective has helped me to develop an even deeper understanding of how the financial system works and how its bits and pieces connect. This in turn generates some interesting inspirations for future research.
“Recently, a new article on “reverse stress testing” co-authored with a friend has been accepted for publication in Mathematical Finance, which is the result of such “interdisciplinary” inspiration taken from applied mathematics, financial stability and policy making.”
Updated November 2022
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Eric Finn Schaanning was drawn to research by a thirst to understand what mechanisms drove the financial crisis. He has just defended his AFR PhD at Imperial College London, during which he developed an operational ‘stress test’ model that is already being used by two European Central Banks. The half Luxembourg, half Norwegian national is now a Senior Advisor at Norges Bank, where he continues to analyse and help improve understanding of how financial institutions react to economic shocks.
Throughout his undergraduate studies, Eric was convinced he would not be pursuing the PhD or researcher path. But all of this changed as Eric began to write his master thesis, as he explains:
“I began to realise how many open questions there are in understanding and modelling systemic risk, both from a financial as well as a mathematical perspective. This got me really excited! I wanted to understand in-depth what amplification mechanisms drove the financial crisis and how one could model these more realistically.”
Soon after, Paul Embrechts who supervised Eric’s master thesis at ETH Zürich, introduced him to his future PhD supervisor, Rama Cont at Imperial College London, and the collaboration with Norges Bank began.
Eric studies systemic risk in financial networks: ‘systemic risk’ is a field that analyses the mechanisms that can enable a localised ‘shock’ – such as the default of a medium-sized bank – to echo through vast parts of the financial system. It then has the potential to threaten the overall stability of the system, a recent example of this being the financial crisis of 2007-09 – the worst financial crisis since the Great Depression of the 1930s.
The challenge of developing a realistic model
The collective reaction of financial institutions is at the very core of the snowball effect that can amplify the impact of financial shocks. ‘Stress tests’, which serve to understand how well a financial institution can withstand an economic crisis, do not currently take the feedback effects from such reactions to the initial shock into account. This is where Eric’s work comes in, he explains:
“My work focusses on developing models that can quantify how banks or other financial institutions react to a stress scenario by deleveraging[1] their portfolios in a realistic way, and infer what spillovers these reactions create.”
“On a conceptual level, this is not new at all. There are many models that describe these dynamics qualitatively. The emphasis of our work lies on ‘quantify’ and ‘realistic’: The challenge is to develop models that regulators can take to their datasets in order to estimate how bad a stress scenario could eventually become.
“Beyond prudential policy, this has also interesting implications for portfolio risk management at individual institutions: in presence of such effects the risk of a portfolio depends on what other institutions hold and do – our model can help to shed light on this.”
Evolving technology calls for new models
Why is it important to ‘update’ systemic risk models? Healthy financial markets are key to a prospering economy. Advances in technology not only impact how these markets work, but also how people and companies interact in them, as Eric explains:
“Think for instance of mobile payment apps, or ‘Robo advisors’ that can make automated portfolio allocation decisions for investors. Traditional economic models may not be pertinent anymore for comprehending and properly analysing the risks in these complex systems, so new tools are needed.
“Overall, markets have become much more intertwined and interconnected, so we need to understand the impact of automation, central clearing, algorithmic execution, high frequency trading and many more, on a deeper level in order to ensure that these markets in fact do what we expect them to, and that they serve society.”
Eric adds: “I would like to contribute to understanding these systems better, with the ultimate goal of helping to create policies that can contain the risks embedded in them. It is very difficult to design policies without having a very detailed knowledge of what it is that one is trying to regulate.”
“I find it incredibly satisfying that my work finds such a direct application”
So how does one go about studying systemic risk? Eric explains it first involves reading many regulatory reports to get the institutional setup right, and then a lot of combining and analysing datasets. During his PhD, Eric’s work focussed mainly on describing the reaction of banks, and coding a simulation module that could be applied in practice.
Eric explains the interdisciplinary approach he took to developing the model: “Getting there was not entirely trivial: the modelling approach is somewhat unorthodox, both from a mathematical and economics point of view. I thought that a data-driven approach would be the most useful and practically relevant, but had no proof of course until recently. So some mathematicians asked me why I was not proving more theorems, while some economists asked me why the model was so mechanical and complex (making it impossible to write down closed-form solutions).”
Eric’s model is already in use by two European Central Banks – both the Bank of England and Norges Bank are in the process of implementing it for their-in house stress tests, to which Eric says: “
I find it incredibly satisfying that my work finds such a direct application.”
Luxembourg has potential for highly innovative research
When asked what potential role Eric sees for Luxembourg in terms of research in his domain, Eric says: “Luxembourg is home to the world’s second largest fund market. I think it goes without saying that properly understanding (and mitigating) the risks around this position is of paramount importance. This is not just in the interest of Luxembourg as financial hub, but given its size, this is arguably a case where one should focus on interconnections, spillover effects and thus systemic risk in general.
“I think two central pieces towards achieving this goal are that (i) data is made available to researchers (under appropriate privacy protections, of course), and (ii) there is a close collaboration between academics, policy makers, and market participants. With these two premises given, I think Luxembourg has the potential to contribute to this field with highly innovative and important research.”
[1] i.e. reducing the size of their portfolios through rapid sales of assets.
Published 10 May 2017
More about Eric Finn Schaanning
Visit Eric Finn Schaanning’s homepage
You can also read about Eric on science.lu (German and French).
About Spotlight on Young Researchers
Spotlight on Young Researchers is an FNR initiative to highlight early career researchers across the world who have a connection to Luxembourg.