Since 2009, the World Bank has been conducting financial crisis simulation exercises and learning valuable lessons on where institutional vulnerabilities lie. These exercises are intended to test, or simply to practice, the use of existing or proposed legal instruments, interagency and/or cross-border agreements, and other crisis management arrangements. More than 20 exercises in all world regions have been executed so far, focusing either on the interaction among top national authorities (typically between the Ministry of Finance, the Central Bank, the Bank and non-bank Supervisors, and the Deposit Insurance Agency), or on the interaction among bank supervisors of different national jurisdictions dealing with cross-border issues.
What do these financial crisis simulations involve? Participants (frequently the Minister of Finance, the Central Bank Governor, the Head of Bank Supervision, and other top national decision makers) receive a stream of (generally bad) news throughout the duration of the exercise, which describes the “scenario” (sequence of challenges) they must deal with the instruments provided by the (real or assumed) legal, regulatory, and operational frameworks. That stream of news contains “public information,” such as newspaper headlines, opinion articles, and statements from public officials,, which are understood to be simultaneously available both to all participating teams and to the general public. It also contains “private information”, such as formal or informal messages from several fictional characters (analysts, bank inspectors, advisors, bankers, journalists, foreign authorities, politicians, etc.). Given the informational asymmetry thus created, participating teams must necessarily find mutually acceptable ways of sharing their respective pieces of information in order to understand the scenario and coordinate their actions.
Exhaustive analysis of the (typically several hundred, mostly written) email messages that are exchanged among the participating teams, as well as between them and the fictitious characters, helps us identify aspects of the legal, regulatory, and/or operational frameworks that would benefit from further work.
While both the still relatively small number of exercises conducted and the diversity of local conditions make comparisons difficult, it is nonetheless possible to offer some tentative preliminary impressions on how participants have frequently responded to common challenges:
• The appetite to undertake corrective actions to address problems identified in an exercise tends to be conditioned by whether they perceive the exercise as their (freely requested) “drill”, or as a (perhaps third-party imposed) “test”.
• Parent/shareholder capacity/willingness to provide capital and liquidity support in a crisis scenario is frequently overestimated.
• Voluntarism, ignoring obvious potential conflicts of interest among different authorities, tends to shape most formal coordination/information sharing agreements.
• Joint analysis of all relevant information is much less common than simple information-sharing.
• Effectiveness of liquidity assistance mechanisms is frequently limited by a narrow set of eligible collateral and/or a lengthy decision making process.
• Coordination of public communications is limited, if not entirely absent, leading to extended periods of silence or, alternatively, mutually contradictory press releases.
Following our simulations, some client countries have requested the Bank’s technical assistance to address the issues identified, and/or requested Bank support to execute new exercises. Mexico has already invested in developing its own capacity by creating a simulations department within the deposit insurance agency (IPAB).
While the events since 2008 have naturally focused our attention on decision making in the particular context of financial crises, the same simulations technology can easily be applied to any other situation involving the interaction of several independent decision makers, in any of the many sectors the World Bank work on.