The crisis, Fed, Quants and stochastic optimal control
The Dodd-Frank (D-F) Financial Reform Bill authorizes the Federal Reserve to monitor the financial services marketplace to identify potential threats to the stability of the US financial system. Alan Greenspan's retrospective indicates what he has learned from the crisis. He argues that the crisis, the housing price bubble, was unpredictable and unavoidable. Greenspan now focuses on desirable capital requirements, or leverage, for banks and financial intermediaries. I explain why the Fed's and Greenspan's views stem from a lack of the appropriate tools of analysis of what is an excessive debt or leverage. The Quants who devised the highly leveraged financial derivatives ignored systemic risk. My theme is that the application of stochastic optimal control (SOC) is an effective approach to implement what the D-F bill is authorizing. I explain: first, what is the optimal capital requirement/leverage that balances expected return against risk. Second, what is a theoretically derived early warning signal of a crisis. Third, I derive an excess debt ratio, equal to the difference between the actual and optimal ratios. The probability of a debt crisis is directly related to the excess debt ratio. The excess debt ratio starting from 2004-05 indicated that a crisis was most likely. The Fed should use this SOC analysis in implementing the Dodd-Frank bill.
If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Stein, Jerome L., 2010.
"A tale of two debt crises: a stochastic optimal control analysis,"
Economics - The Open-Access, Open-Assessment E-Journal,
Kiel Institute for the World Economy (IfW), vol. 4, pages 1-24.
- Stein, Jerome L., 2009. "A tale of two debt crises: a stochastic optimal control analysis," Economics Discussion Papers 2009-44, Kiel Institute for the World Economy (IfW).
- Jerome L. Stein, 2008. "A Tale of Two Debt Crises: A Stochastic Optimal Control Analysis," CESifo Working Paper Series 2220, CESifo Group Munich.
- Jerome L. Stein, 2005. "Optimal Debt And Endogenous Growth In Models Of International Finance," Australian Economic Papers, Wiley Blackwell, vol. 44(4), pages 389-413, December.
- Shojai, Shahin & Feiger, George, 2010. "Economists’ hubris – the case of risk management," Journal of Financial Transformation, Capco Institute, vol. 28, pages 27-35.
- Wendell H. Fleming, 2005. "Optimal Investment Models With Minimum Consumption Criteria," Australian Economic Papers, Wiley Blackwell, vol. 44(4), pages 307-321, December.
- Shojai, Shahin & Feiger, George & Kumar, Rajesh, 2010. "Economists’ hubris — the case of equity asset management," Journal of Financial Transformation, Capco Institute, vol. 29, pages 9-16.
- Wendell Fleming & Jerome L. Stein, 2002.
"Stochastic Optimal Control, International Finance and Debt,"
CESifo Working Paper Series
744, CESifo Group Munich.
- Fleming, Wendell H. & Stein, Jerome L., 2004. "Stochastic optimal control, international finance and debt," Journal of Banking & Finance, Elsevier, vol. 28(5), pages 979-996, May.
- Stein Jerome & Wendell Fleming, "undated". "Stochastic Optimal Control, International Finance and Debt," EcoMod2002 330800063, EcoMod.
When requesting a correction, please mention this item's handle: RePEc:eee:ecmode:v:28:y:2011:i:1-2:p:272-280. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Shamier, Wendy)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.