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Regulators need to be stress-tested, too

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Right before the December holidays, U.S. Treasury Secretary Steven Mnuchin released a statement intended to assure the public that, after speaking with the CEOs of the six largest Wall Street banks, the firms had “ample liquidity available for lending” and that “markets continue to function properly.”

It was bizarre. Telling financial market participants, policymakers and the broader public not to worry about the immediate stability of the financial system — when no one was worried —precipitated the exact opposite outcome. The decision to release such a bold statement, along with some related actions, calls into question Mnuchin’s ability to manage an actual crisis.

Banks are stress tested to ensure their balance sheets can handle a large financial shock and an economic downturn. We should use crisis simulations, or wargames, to stress test regulators and make sure they can handle such a shock as well.

Aside from the puzzling decision to release the statement, its execution also raised questions. Secretary Mnuchin only called six of the eight banks that qualify as U.S. global systemically important banks, or G-SIBs, failing to call the two G-SIB custody banks: Bank of New York Mellon and State Street. These two custody banks hold about $65 trillion in assets under custody and administration and are vital to the plumbing of the financial system. There are certainly some circumstances where excluding these banks and only speaking with the six main Wall Street banks would be appropriate. But Mnuchin’s statement went beyond liquidity and lending and included assurances on overall market functioning. The CEOs of the two G-SIB custody banks would be important to talk to if there was any concern on overall market functioning, especially regarding payment systems and short-term funding markets.

Furthermore, Mnuchin organized a meeting the following day of the President’s Working Group on Financial Markets to discuss the state of the financial system. This body, created by Executive Order in 1988, only includes a few of the financial regulators and hasn’t officially met in many years. The Dodd-Frank Act replaced the need for the working group by creating the Financial Stability Oversight Council, a body that brings together all financial regulatory agencies to monitor and address threats to financial stability. It’s unclear why Secretary Mnuchin, who serves as Chairman of the FSOC, didn’t call for a meeting of the Council. Treasury Secretaries Geithner and Lew both called special meetings of the FSOC to discuss financial sector turbulence.

Secretary Mnuchin’s curious decision-making likely stems from, in part, a lack of crisis management experience. Few current regulators were in government during the acute phase of the 2007-2008 financial crisis, and none were in key roles. Even during the crisis, few regulators had any relevant crisis experience, and it showed. Communication with the public was not always constructive, the legislative strategy was at times deeply flawed, and regulators were trying to figure out how and when to use their emergency authorities on the fly.

The risks associated with a lack of crisis experience among regulators will only grow in importance the further away we get from the last crisis. One way to help mitigate the risk is to stress test regulators through formalized, integrated financial crisis simulations. These simulations, as professor John Crawford of UC Hastings College of the Law has outlined, would be akin to military wargaming. Regulators should be presented with an economic scenario detailing a set of shocks and deteriorating financial conditions. These shocks could include the failure of multiple complex banks and nonbank financial companies, breakdowns in key funding markets or payment systems, geopolitical unrest, cyber-attacks and other creative stressors.

Regulators, including key members of their staffs, would have to work with one other to coordinate a collective response, including mock communications with the public and market participants, legislative strategies and use of their respective emergency authorities. Throughout the simulation, the state of the financial system would evolve in response to actions taken by regulators. The crisis simulation would provide participants with some level of experience in financial crisis management. In addition, the simulations may help regulators identify shortcomings in current regulatory approaches or statutory authorities.

The Office of Financial Research and the FSOC should design this annual or biannual exercise for the 10 voting and 5 non-voting members of the Council, consulting with the Department of Defense regarding best practices for wargames. Major foreign financial regulatory counterparts should also be invited to participate in elements of the simulation, as responding to a global financial crisis requires substantial cross-border coordination. Regulators should provide the public with some level of transparency surrounding the results and lessons learned from the exercise, balancing the need to keep aspects of the deliberations and mock supervisory decisions private.

Some agencies have engaged in similar ad hoc crisis exercises that have either been siloed within a single agency or have only focused on one aspect of a financial crisis. These exercises are a step in the right direction, but there is a need for regular, structured, and integrated simulations.

Secretary Mnuchin’s pre-holiday blunder was an acute example of the larger problem of crisis management experience facing the current group of financial regulators, and it’s a problem that is set to intensify as we move further away from the last crisis.

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