When the D.C. Circuit Court of Appeals struck down the U.S. Securities and Exchange Commission’s (SEC) proxy access rule in 2011, it cited the agency’s failure to provide a rigorous cost-benefit analysis. Critics of that court decision argued that it created a burdensome new standard that would destroy the SEC’s ability to issue regulations.
Of course, critics of cost-benefit analysis advanced that very same argument in 1981 when President Ronald Reagan issued an executive order making cost-benefit analysis a central tool of regulatory decision-making. More than three decades later, the U.S. Environmental Protection Agency (EPA), the Occupational Safety and Health Administration (OSHA), and the National Highway Traffic Safety Administration (NHTSA) widely apply cost-benefit analysis to regulations with an expected annual economic impact of $100 million or more, and these and other federal agencies have issued hundreds of regulations supported by cost-benefit analysis over the years. If cost-benefit analysis has become the standard for decision-making about environmental, health and safety regulation, why not use it for financial regulation?
Drawing on the work of a conference on cost-benefit analysis for financial regulation held in October 2013, the University of Chicago’s Eric Posner and Glen Weyl build a case for applying cost-benefit analysis to financial regulation in a recent paper. Although President Obama’s Executive Order 13579 does not require independent agencies—including the majority of financial regulators—to conduct cost-benefit analysis, Posner and Weyl argue that applying cost-benefit analysis to financial regulation would improve transparency and accountability, limit gaming, ensure consistent agency decision-making, and cool ideological battles. They propose a framework outlining how agencies could apply cost-benefit analysis to financial regulation. Ultimately, the authors recommend that the Office of Information and Regulatory Affairs institutionalize cost-benefit analysis principles for financial regulators and bring financial regulatory agencies under its supervision.
Posner and Weyl start by presenting a general defense of cost-benefit analysis as a tool for regulatory decision-making. They claim that before the era of cost-benefit analysis—when agencies relied on an intuitive balancing of the qualitative benefits and costs of regulatory actions—it was difficult to understand why regulators would choose particular standards. Yet, unless an agency quantifies and monetizes expected outcomes, it has no idea how many deaths, strokes, or heart attacks a pollutant reduction could prevent annually, according to the authors. Moreover, while critics of cost-benefit analysis have long contended that outcomes like the reduction of the risk of death to populations or environmental damage are hard to measure, Posner and Weyl say that economists have developed sophisticated—albeit imperfect—methodologies to address these difficult questions.
In addition, Posner and Weyl point to a number of second-order advantages of cost-benefit analysis. First, they argue that cost-benefit analysis checks agencies’ ability to issue regulations on the basis of politics or ideology, thereby enhancing regulators’ legitimacy and transparency. Second, by offering a clear justification that provides the “spirit” behind the rule, cost-benefit analysis purportedly makes regulatory arbitrage more challenging for regulated entities and enables regulations to more readily adapt to changing circumstances. Third, by using a consistent cost-benefit analysis protocol, agencies may be able to ensure that different rules fit and interact well with one another, rather than undermining each other. Finally, Posner and Weyl say, creating a coherent set of principles for cost-benefit analysis could help clarify an agency’s mission, thereby motivating regulators with a sense of purpose.
Posner and Weyl also present and then counter specific objections to using cost-benefit analysis in finance. First, critics claim that a financial cost-benefit analysis literature—complete with ready-to-use standards and methodologies—does not yet exist. While this is true, the authors acknowledge, they point to the rapid development of cost-benefit analysis in environmental, health and safety regulation in response to President Reagan’s executive order. If the SEC were to rise to the challenge posed by the D.C. Circuit Court of Appeals, Posner and Weyl say, a large industry for conducting such analyses would likely develop, as has happened in other regulatory spaces.
Second, while critics contend that financial valuations are harder to quantify, this is not necessarily true, say the authors. After all, while the EPA must measure difficult-to-value effects like life and health, financial regulation mostly has to do with far less subjective, easy-to-measure dollars.
Finally, although financial cost-benefit analysis may neglect harder-to-quantify elements in the same way that environmental regulation may neglect quality-of-life effects, Posner and Weyl argue that compelling agencies to examine alternative outcomes via cost-benefit analysis would be far superior to an intuitive balancing approach.
Posner and Weyl further develop a framework for applying cost-benefit analysis to financial regulation. Complex financial regulation must be rooted in simple, robust and consistent principles, they say. The most fundamental goal of cost-benefit analysis for financial regulation, they assert, should be to measure the effects of expected losses in the case of a financial bailout and multiply the probability that such a bailout would trigger a crisis by the social loss associated with the crisis.
Although banks will have an incentive to maximize their exposure to risk while avoiding the negative externalities associated with excess leverage, Posner and Weyl argue that regulators should use empirical data regarding entities’ actual positions to distinguish risk-increasing and risk-reducing trades, rather than relying on the names that entities are given or how they register with agencies. Any lost revenue arising from short-lived regulatory arbitrage should not be considered a “cost” under financial cost-benefit analysis because it creates no social value. In addition, the reduction of available credit to consumers as a result of financial regulation should neither count as a cost nor a benefit under cost-benefit analysis of financial regulations because credit is likely oversupplied, according to the authors. Posner and Weyl say that cost-benefit analysis must directly focus on quantifying the benefits financial regulations bring to the extent that they help economic agents act in a rationally risk-averse way.
Posner and Weyl conclude by recommending that the SEC and other independent financial regulators embrace cost-benefit analysis. While the president could issue a new executive order directing financial regulators to conduct cost-benefit analysis, because the president has limited authority to fire regulators at independent agencies, this action is unlikely to have a strong effect, say the authors. Instead, they call on OIRA to bring financial agencies under its supervision and work with regulators to institutionalize a cost-benefit analysis protocol. After all, they ask, if environmental, health and safety agencies use cost-benefit analysis, why shouldn’t financial regulators do so as well?