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FINANCIAL STRESS in an ADAPTIVE SYSTEM: from EMPIRICAL VALIDITY to THEORETICAL FOUNDATIONS by MIKHAIL V. OET Submitted in Partia

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FINANCIAL STRESS in an ADAPTIVE SYSTEM: from EMPIRICAL VALIDITY to THEORETICAL FOUNDATIONS by MIKHAIL V. OET Submitted in Partia FINANCIAL STRESS IN AN ADAPTIVE SYSTEM: FROM EMPIRICAL VALIDITY TO THEORETICAL FOUNDATIONS by MIKHAIL V. OET Submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy Weatherhead School of Management Designing Sustainable Systems CASE WESTERN RESERVE UNIVERSITY May, 2016 CASE WESTERN RESERVE UNIVERSITY SCHOOL OF GRADUATE STUDIES We hereby approve the thesis/dissertation of Mikhail V. Oet Candidate for the degree of Doctor of Philosophy. * Committee Chair Kalle Lyytinen, Ph.D., Case Western Reserve University Committee Member Lucia Alessi, Ph.D., European Central Bank Committee Member Agostino Capponi, Ph.D., Columbia University Committee Member Myong-Hun Chang, Ph.D., Cleveland State University Committee Member Corinne Coen, Ph.D., Case Western Reserve University Date of Defense March 5, 2016 *We also certify that written approval has been obtained for any proprietary material contained therein. Copyright © by Mikhail V. Oet All rights reserved Dedication To my family. In every systematic inquiry (methodos) where there are first principles, or causes, or elements, knowledge and science result from acquiring knowledge of these; for we think we know something just in case we acquire knowledge of the primary causes, the primary first principles, all the way to the elements. It is clear, then, that in the science of nature as elsewhere, we should try first to determine questions about the first principles. The naturally proper direction of our road is from things better known and clearer to us, to things that are clearer and better known by nature; for the things known to us are not the same as the things known unconditionally (haplôs). Hence it is necessary for us to progress, following this procedure, from the things that are less clear by nature, but clearer to us, towards things that are clearer and better known by nature. ——Aristotle, Phys. 184a10–21 i Table of Contents List of Tables ...................................................................................................................... v List of Figures ................................................................................................................... vii Abstract ............................................................................................................................... x Executive Summary ............................................................................................................ 1 Problem of Practice ........................................................................................................... 1 Research Motivation and Goals ........................................................................................ 5 Research Design ................................................................................................................ 8 Conceptual map ............................................................................................... 8 What methods are appropriate? ....................................................................... 9 Research plan ................................................................................................ 11 Chapter Outlines ............................................................................................................. 14 Chapter 1: The Problem of Financial Stress in Adaptive System ..................................... 25 1.1. Theoretical Framing ................................................................................................. 25 1.1.1. Issues framed by research in financial system complexity ................. 25 1.1.2. Issues framed by research in financial system stability ...................... 30 1.2. Research Precedents ................................................................................................. 31 1.2.1. Financial system stress construction ................................................... 31 1.2.2. Stress factor decomposition ................................................................ 33 Chapter 2: Does Financial Stability Matter to the Fed in Setting the US Monetary Policy? ........................................................................................................................................... 37 2.1. Introduction .............................................................................................................. 38 2.2. Conceptual framework ............................................................................................. 41 2.3. Data and methodology ............................................................................................. 45 2.3.1. Content analysis: FOMC discussions of monetary policy .................. 46 2.3.2. Taylor guide to monetary policy ......................................................... 59 2.4. Thematic and Tri-mandate Monetary Policy Models .............................................. 66 2.4.1. Main results ......................................................................................... 66 2.4.2. Sign expectations ................................................................................ 69 2.4.3. Significance ......................................................................................... 74 2.5. Discussion ................................................................................................................ 82 2.5.1. Counterarguments ............................................................................... 82 2.5.2. Methodological limitations ................................................................. 85 2.5.3. Implications ......................................................................................... 86 Chapter 3: How to Evaluate Measures of Adverse Financial Conditions? ....................... 89 3.1. Introduction .............................................................................................................. 89 3.2. Literature review ...................................................................................................... 92 3.3. Methodology ............................................................................................................ 97 3.3.1. Classification problem ........................................................................ 98 3.3.2. Multi-dimensional signaling ............................................................... 99 3.3.3. Comparison of identification properties ........................................... 100 3.3.4. Comparison of early warning properties ........................................... 104 3.4. Case Study: Measures of US Systemic Conditions (1976-2014) .......................... 105 3.4.1. Data and sampling ............................................................................. 105 ii 3.4.2. Results ............................................................................................... 109 3.5. Conclusion: Implications and limitations .............................................................. 122 Chapter 4: Stress in Heterogeneous Financial Agents: Validity and Dynamics ............. 126 4.1. Introduction ............................................................................................................ 126 4.2. Theoretical Foundation .......................................................................................... 128 4.2.1. Motivation ......................................................................................... 128 4.2.2. Hypotheses ........................................................................................ 129 4.2.3. Micro-level stress in agents and instruments:A conjecture .............. 134 4.3. Empirical Comparison ........................................................................................... 142 4.3.1. Empirical identification of micro-level stress ................................... 146 4.3.2. Empirical macro-level stress in a set of representative markets ....... 146 4.3.3. Exploratory factor analysis ............................................................... 148 4.3.4. Dynamic factor analysis .................................................................... 151 4.4. Discussion .............................................................................................................. 176 Chapter 5: Connecting the Micro and Macro Levels of Financial Stress ....................... 180 5.1. Agent Choices and Transmission Dynamics ......................................................... 180 5.1.1. Dynamic analysis of agent stress ...................................................... 181 5.1.2. Agent preferences ............................................................................. 182 5.1.3. The stress transmission process ........................................................ 183 5.2. Methodology .......................................................................................................... 185 5.2.1. Revealed preference analysis ............................................................ 185 5.2.2. Stress dynamics ................................................................................. 190 5.3. Results .................................................................................................................... 192 5.4. Integrated Research Findings ................................................................................. 199 5.5. Conclusion ............................................................................................................. 200 Appendix 1: Chapter 2 Regime
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