Wargaming Financial Regulation

Several years ago, in a review of Andrew Ross Sorkin’s excellent review of the 2008 financial crisis, Too Big To Fail, I suggested:

Enough is now known about humans’ cognitive tics to start trying to tame them. What if the regulators of financial institutions were required to undergo intensive and ongoing training in behavioural economics and cognitive psychology? What if people within financial institutions were required to do the same? What if they were required to apply these principles to their own balance sheets and publish their findings to shareholders? In short, what if we started thinking about how to stop crises emerging in the first place? We could also profitably think about what to do when crises do emerge. What about advance planning and “war-gaming” for crises? Would it not make sense for the various regulators to plan and develop protocols as to how they ought to react in crisis situations? It might even be possible to enact legal frameworks to help manage financial crises. Unlike comprehensive global financial regulation, countries would not have a strong incentive to hold out for a better deal, simply because of the uncertainty about the precise form future crises would take. Judging by the chaotic scenes and crossed lines of communication that characterised the financial crisis of 2008, the development of such frameworks, domestic and international, cannot come too soon.
So I was intrigued to see Mehrsa Baradaran’s essay, Regulation by Hypothetical, in which she advocates “financial war games” (summarized here). She takes aim at existing forms of regulation, both traditional capital and disclosure requirements and the “regulation by hypothetical” forms that have emerged since the crisis — stress tests and living wills — and prefers a more dynamic approach involving war games that “aggregate the thousands of decisions by individuals at every stage in an action to accurately depict the way myriads of mundane decisions can have significance over time”:
Conducting war games would certainly benefit individual firms as the exercise allows firms to assess the scope of vulnerabilities, the strength of their contingency plans, and their general risk profiles. However, to measure systemic risk, regulators need more than just firm-specific information. Regulators need to measure risks across firms and understand how one firm’s vulnerabilities can affect the system. For example, the possible failure of the insurer AIG, which was not overseen by any banking regulators, threatened to collapse the entire financial system because AIG had insured trillions of derivatives for almost every large financial institution. Regulators must be able to see the system as a whole to understand what risks threaten it. Similarly, when the military conducts a war game of a potential Syrian strike, they must include players representing Iranian, Russian, Chinese, and Israeli interests to fully understand and prepare for each nation’s potential response to an attack and prepare for all those contingencies.
Her ultimate policy prescriptions are cautious: she recognizes that war games are likely to be costly — and, of course, subject to gaming by the participants. I wonder whether it would not be better to start the war gaming process with regulators themselves — a process which could presume self-interest on the part of mischievous market actors — and thereby build regulatory competence in responding to financial crises. If internal war games proved sufficiently robust, perhaps then they could usefully be extended to include private parties.
I came across the essay via the Yale Journal on Regulation’s super new blog, Notice and Comment.

This content has been updated on November 21, 2014 at 13:42.