Cost-benefit analysis of financial regulation: case studies and implications.

AuthorCoates, John C., IV
PositionIntroduction through II. A Critical Assessment of judicial Review of CBA/FR, p. 882-926

ARTICLE CONTENTS INTRODUCTION I. WHAT DO PEOPLE MEAN BY "COST-BENEFIT ANALYSIS"? A. Policy Versus Law B. Quantities (or Guesstimates) Versus Concepts C. Camouflage Versus Discipline D. Alternatives to Quantified CBA/FR 1. The "Alternative" of Expert Judgment 2. Monetary Policy: A Limiting Example II. A CRITICAL ASSESSMENT OF JUDICIAL REVIEW OF CBA/FR A. Existing CBA/FR Law B. A Critical Assessment of Judicial Review of CBA/FR C. Congressional Oversight, Regulatory Initiatives, and Proposed Legislation III. HOW MIGHT CBA OF FINANCIAL REGULATION WORK? A. Case Study #1: Control Disclosures for Public Companies 1. The SEC's CBA of Rules Implementing SOX 404 2. An Overview of CBA/FR of SOX 404 3. Estimating the Incidence of Fraud and Its Direct Costs 4. How Should Transfers Be Treated? 5. Measuring the Externalities and Psychological Costs of Fraud 6. Estimating Causal Effects of SOX 404 7. What Baseline and Set of Counterfactuals Should Be Used? 8. How Do Compliance Costs Vary Across Firms and over Time? 9. Modeling and Measuring Chilling Effects of Financial Regulation 10. Summary and Illustrative Integrated Assessment Model B. Case Study #2: Independent Boards for Mutual Funds 1. The Rules 2. The Aftermath of Chamber of Commerce II 3. What Would CBA of the Mutual Fund Governance Rules Require? 4. The Aftermath of the Aftermath C. Case Study #3: Heightened Capital Requirements for Banks 1. Regulatory Response 2. CBA/FR of Basel III 3. Costs of a Financial Crisis 4. Frequency of Financial Crises 5. Effects of Higher Capital Requirements on Financial Crises 6. Costs of Higher Capital Requirements: Less Lending? D. Case Study #4: The Volcker Rule E. "Gold Standard" Examples of CBA/FR 1. The SEC's Cross-Border Rules on Swaps 2. The FSA's Mortgage Market Reforms a. The FSA's CBA/FR b. Assessing the FSA's CBA/FR F. Summary of Case Studies IV. WHAT ARE THE IMPLICATIONS OF THESE CASE STUDIES? A. Why Is Quantified CBA/FR So Unreliable? 1. Finance Is Central to the Economy 2. Finance Is Social and Political 3. Finance Is Non-Stationary B. New CBA/FR Mandates Should Be Passed Only If CBA/FR Satisfies CBA C. Existing CBA/FR Laws Are Little Better in Practice D. CBA/FR Remains a Potentially Valuable Component of Policy Analysis CONCLUSION INTRODUCTION

A movement is afoot to impose cost-benefit analysis (CBA) on financial regulation (CBA/FR). (1) The housing and financial crises of (2008) led to the Dodd-Frank Act, (2) which restructured the financial regulatory agencies, mandated more than (200) new rules, and required changes to many older rules. (3) The sweep of regulatory change has reignited criticism for failure to base the changes on adequate CBA/FR. (4) Bills have been introduced to provide explicit authority for the President to require CBA/FR from independent agencies, (5) even as critics argue that existing law already requires the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) to conduct a particular form of CBA/FR: judicially enforced quantification. (6) One panel of the United States Court of Appeals for the District of Columbia Circuit, composed entirely of Republican-appointed judges, held that existing law requires the SEC to quantify the costs and benefits of its proposed rules, (7) while another judge--appointed by President Obama to the D.C. Circuit--subsequently held that such quantification is not mandatory, at least when the SEC is required by statute to adopt a rule, and the benefits sought to be achieved are humanitarian and not economic in nature. (8)

This Article critiques efforts to impose judicially reviewed, quantified CBA on independent financial agencies, while also attempting both to explore how conceptual CBA/FR could lead to better policy and to advance the substantive project of quantitative CBA/FR itself. This combination of objectives represents a moderate stance, between the polar positions that often characterize debates over CBA; the Article neither rejects it utterly nor embraces it naively. Rather, the Article explores how CBA is likely to function in the near term as applied to financial regulation and assesses the costs and benefits of using CBA/FR. In other words, the Article begins to develop a CBA of CBA/FR itself. The results of the exploration not only call into question simplistic efforts to mandate CBA--particularly quantified CBA, and particularly when enforced through judicial review by generalist courts--but also should help those who favor economic analysis of law to appreciate how CBA might advance and clarify policy analysis of financial regulation, rather than retard or obscure it.

Part I analyzes CBA generally, noting that it (a) can be either a framework for policy analysis or a legal means to discipline agencies and (b) can consist of either conceptual analysis or efforts at quantification. Part I also briefly reviews CBA's origins in U.S. legal history to show that it can be used to camouflage as well as to discipline, referring to the Taylor Rule to explain why even CBA's advocates do not propose to require CBA for monetary policy. Often, CBA is defended in part on the grounds that supposed alternatives--such as expert discretionary judgment--are no better, and often worse, than CBA. In fact, Part I suggests, CBA may turn out not to be an alternative to reliance on judgment: instead, expert judgment is a core and necessary component of CBA, as it is for any process of assessing and adopting financial regulations.

Part II describes existing law relevant to CBA/FR and investigates ongoing efforts to promote quantified CBA/FR. Chief among these efforts has been a string of high-profile CBA cases over the last decade in which courts have struck down financial regulations. Part II critically assesses those cases, showing they have been poorly reasoned, premised on mistakes, inconsistent with precedent, and based on misunderstandings about what CBA/FR can reasonably be expected to do. Nevertheless, those decisions have fueled efforts in the agencies themselves to undertake more CBA/FR. More problematically, those cases have also fueled efforts in Congress to give courts an even more expanded role in enforcing a general mandate for the independent agencies to include quantified CBA in rulemaking.

Part III develops case studies of how quantified CBA/FR might be conducted on six significant and representative financial regulations, drawing on relevant academic research to outline the tasks that need to be tackled to conduct CBA/FR on those rules. The case studies show that quantified CBA/FR amounts to no more than "guesstimation," entailing: (a) causal inferences that are unreliable under standard regulatory conditions; (b) the use of problematic data; and/or (c) the same kinds of contestable, assumption-sensitive macroeconomic or political modeling used to make monetary policy.

Part IV concludes by reviewing the implications of the case studies. Anyone who supports CBA should agree that CBA should be conducted only to the extent it passes its own test--that is, only if CBA itself will produce more benefits than costs. Perhaps surprisingly, given that CBA has been part of administrative law for decades, CBA of CBA has itself never been adequately conducted, leaving the first-stage choice of when to perform CBA/FR itself in the realm of judgment rather than science. Part IV begins the task of outlining a CBA of CBA, both generally and in the context of financial regulation. It argues that the benefits of CBA/FR have been low in the past and are likely to remain low in the near future, while its costs will depend on the precise institutional and legal context in which it is pursued.

CBA/FR's benefits are likely to remain low because it is by definition about finance: finance is at the heart of the economy; is social and political; and is characterized by non-stationary relationships that exhibit secular change (that is, long-term structural changes). These features undermine the ability of science to precisely and reliably estimate the effects of financial regulations, even retrospectively. Whenever agencies face such sensitive and speculative forecasting abilities, quantified CBA is not capable of disciplining regulatory analysis. It will generate low benefits in the form of reduced agency costs (in part by counteracting cognitive biases) or increased transparency. Moreover, CBA/FR will produce costs: resources consumed, regulatory delay, diffusion of regulatory focus, and potential decreases in regulatory transparency--particularly if regulatory agencies and courts involved in reviewing agency action do not have strong incentives to be honest about the limits of the results.

At the same time, CBA/FR is a useful conceptual framework, and quantified CBA/FR is a worthy long-term research goal. Attempts to quantify may advance the research needed to achieve reliable, precise estimates, and this makes quantified CBA/FR a worthwhile project for agencies to pursue. But the current benefits of CBA/FR remain low, because their real effects remain far off in time; like any regulatory benefits, the benefits of CBA/FR should be discounted to present value.

Completing a full, quantified CBA of CBA would require evidence and new research methods: studies of the degree to which CBA results in better regulations or more transparency in the regulatory process, as well as quantified estimates of the costs--delay, confusion, camouflage, partisanship--that CBA can introduce. Until evidence is developed to illuminate when CBA/FR passes its own test, courts and secondary agencies (that is, agencies other than those charged with rulemaking responsibility) should have no role in second-guessing the choice of when to conduct CBA/FR, or the details of CBA/FR when it is used. (9) Not only should new legal CBA/FR mandates be resisted as likely to worsen policy outcomes, but existing interpretations of the Administrative Procedure Act...

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