A New Paradigm for Understanding and Controlling Systemic Risks in Financial Markets

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The recent financial crisis started as a banking crisis. As is typical with such crises, the resulting contraction of credit in the financial markets spread to the real economy. The effects of the crisis have been devastating: unemployment has skyrocketed and many people are struggling to make ends meet. Although the current crisis has been severe, such crises occur quite frequently and have a common theme: rising asset prices fueled by an excessive accumulation of risk. Unfortunately, current regulatory policy is not sufficient to prevent or mitigate risk buildup. The objective of this research is to apply proven, robust tools from systems theory to develop accurate models of the financial market and to apply such models to the development of control laws and game-theoretic mechanisms that can be used by regulators to design practical regulatory policies that correctly balance risk accumulation and growth. Intellectual Merit: Boom-Bust risks in the financial market are heavily dependent on the role of the financial intermediaries that undertake short-term borrowing in order to finance long-term investments. The main factors contributing to such systemic risks are: the mismatch in the duration between borrowing and investing, the investment strategies of such intermediary institution that maintain a high leverage when long term assets are high, and the Federal Reserve?s strategies in adjusting short-term borrowing rates. The proposed dynamic model of the market will address these sources of risks in a control and game-theoretic framework in order to 1) provide a rigorous explanation of the recent credit crises that capture the feedback interaction between all the players in the market, 2) propose robust and dynamic market mechanisms that mitigate the risk induced by the intermediary institutions, and 3) propose simple and intuitive strategies for the Fed that can translate into implementable regulatory policy for the market.Broader Impact: The broad impact of this project can be summarized as follows: Research: The research literature on systemic risk is still in its infancy, even in the economics profession where most of the focus has centered exclusively on the banking sector and monetary policy. Only in the aftermath of the recent financial crisis have macroeconomists begun to pay attention to other parts of the financial industry such as derivatives, mortgage-backed securities, real estate, and hedge funds. Even so, the majority of macroeconomic thinking is still dominated by stationary linear rational expectations equilibrium models, not by feedback loops, system identification, nonlinear dynamics, and robust control methods. A systems engineering approach to modeling the global economy has the potential to change the way economists think about systemic risk. Education: The project also hopes to have broad impact on the educational front by exposing engineering students to challenges posed by current economic conditions. A successful application of control theory and systems theory to economic systems will create many opportunities for master?s and doctoral theses in engineering. The approaches developed from this research will be incorporated in the curriculum at MIT, which will then be made publicly available via MIT?s Open Course Ware. The proposed tools will be integrated with the tools used by economists and various financial institutions. Policy: Regulators and policymakers are currently engaged in re-vamping the legal, accounting, and regulatory infrastructure of the economic and financial system, and a systems engineering approach can be indispensable to these deliberations. In the same way that control theory has had an indelible impact on national aerospace and defense policy over the last three decades, a similar kind of impact can be achieved in crafting economic and financial policy.