Magazine article Regulation

The Case for Cost-Benefit Analysis of Financial Regulations: CBA Has Become Widely Accepted for Environmental and Safety Regulation, So Why Not for Finance?

Magazine article Regulation

The Case for Cost-Benefit Analysis of Financial Regulations: CBA Has Become Widely Accepted for Environmental and Safety Regulation, So Why Not for Finance?

Article excerpt

Cost-benefit analysis (CBA) has become the standard method used by regulatory agencies like the Environmental Protection Agency to evaluate potential regulations, yet there is a major, puzzling exception. The financial regulatory agencies--the Securities and Exchange Commission, the Commodities Futures Trading Commission, the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency (OCC), among others--do not use CBA. This is a bizarre anomaly in our regulatory system, and Congress and the judiciary have recently woken up to it. In 2011, the D.C. Circuit Court of Appeals struck down an SEC regulation because the SEC failed to provide an adequate CBA for it. And in Congress, Sens. Mike Crapo (R-Idaho) and Richard Shelby (R-Ala.) have introduced a bill that would require the financial regulators to conduct CBA of proposed regulations.

Those developments have thrown financial regulators into a panic. When the two of us conducted interviews at a major financial regulator last summer about a separate regulatory proposal, we heard again and again about worries that the agency would not be able to conduct cost-benefit analyses that would satisfy the D.C. Circuit. The problem, as we will discuss below, is that because regulators never did adequate cost-benefit analyses in the past, they do not know how to do it now, nor is there an academic literature that tells them how to do it. They were like blind men locked in a dark room scrambling to find the key to the door.

To address that problem, we convened a conference on "Cost-Benefit Analysis for Financial Regulation" at the University of Chicago with funding from the Alfred Sloan Foundation. We invited leading financial economists and lawyers to discuss ways for regulators to conduct financial CBA. Below we discuss what we learned from the conference.


First, some background: Regulators receive authority to regulate from Congress, which typically provides them with very broad discretion. Congress tells regulators to control air or water pollution but, with some exceptions, does not tell them exactly what clean air and water standards to use. Similarly, Congress doesn't tell the Occupational Safety and Health Administration how high safety railings in workplaces must be; OSHA itself makes such judgments pursuant to a broad grant of power. Thus, regulators must decide on their own how strictly to regulate. When the EPA sought to remove arsenic from water supplies, it could not order municipal water supplies to reduce the level to zero because that is essentially impossible and trace amounts of arsenic cause little or no harm. The EPA needed to figure our a standard that is strict enough to advance human health but not so strict as to raise the price of water unduly.

Before the era of CBA, agencies appeared to use a kind of intuitive balancing where they took into account the qualitative benefits from stricter regulation (health improvements) and the costs, while also considering other factors such as job loss, political pushback, and so on. The explanations that accompanied the regulations overflowed with unilluminating boilerplate and it was difficult to understand why regulators chose a particular standard rather than one that was stricter or less strict.

All of that changed in 1981 when President Ronald Reagan issued an executive order directing regulatory agencies to conduct CBA of major" regulations, meaning regulations that had an economic impact of at least $100 million per year. Regulations that failed a CBA or were not accompanied by a valid CBA would be blocked by the Office of Information and Regulatory Affairs (OIRA), an office within the Office of Management and Budget, and returned to the regulator for additional work.

Many liberals criticized President Reagan because they believed the cost-benefit requirement was just a bureaucratic hurdle that would slow down regulation or compel deregulation. …

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