Cost-Benefitting Financials Regulations

In recent years there has been a growing movement within certain factions of Congress, the judicial branch, and the legal academy to require all financial regulations to be subject to strict cost-benefit review (CBR). Rival commentators meanwhile argue that historically conceived CBR would be ill-advised for financial regulations due to the interconnected nature of financial markets, poor data quality, and questions of practical political economy. In this review I will explain the rationale behind agency-required CBR analysis, survey the arguments both for and against detailed CBR as applied to financial regulation, and explain how strictly implemented CBR would affect the viability of reforms like increased capital requirements. I will conclude with my own opinion on the propriety of financial CBR, including practical and theoretical constraints not yet explored in prior analysis.

Under Executive Order 13563, executive agencies are mandated to calculate the impact of all economically significant rules, including a calculation of the anticipated present and future benefits and costs as accurately as possible (Sunstein 2014, p. 1380). Executive agency regulations and their CBA calculations are subjected to review by the Office of Information and Regulatory Affairs (OIRA) situated in the White House Office of Management and Budget (OMB). However, many of the agencies tasked with formal rulemaking are not a division of the executive branch, are legally independent, and are thus exempt from formal OIRA review and executive mandates. This exclusion includes the SEC, CFTC, CFPB, OCC, FDIC, and the Federal Reserve—nearly all of the primary regulators of the financial industry. As a result, “presidents desiring these agencies to engage in CBA have therefore been forced to resort to ‘encouraging’ these agencies to follow the CBA protocols set forth in the CBA [executive orders] as if they were subject to OIRA oversight” (Bartlett 2014, p. S385). However, even independent agencies face constraints on their regulatory actions—under the Administrative Procedure Act (APA), federal courts can strike down agency rulemaking that are “arbitrary and capricious.” Muddling up the jurisdictional issue further, not all independent agencies are subject to federal court review (e.g., OCC, FDIC), and courts had, until the misguided 2013 decision Business Roundtable v. SEC, historically not read in a strict CBA analysis to financial regulations under the arbitrary and capricious standard.

It is against this institutional backdrop that we find ourselves grappling with recent proposals for mandated CBA review. It should be noted that even in the absence of formal CBA analysis, most of the relevant agencies have internal policies that require the agency to engage in some measure of CBA in connection with their rulemaking (Bartlett 2014, p. S388). However, for some members of the legislature and financial community, the informal and inconsistent nature of economic analysis conducted within the regulatory system is insufficient. Senator Mike Crapo, a leading Republican on the Senate Committee on Banking, Housing and Urban Affairs, has remarked that “regulators need to conduct rigorous analysis of the costs and benefits of their rules and the effects those rules could have on the economy” (Bartlett 2014, p. S390-91) (emphasis added). Crapo and others have proposed the Financial Regulatory Responsibility Act of 2013 (FRRA), which would require all independent agencies to provide both quantitative and qualitative assessments for all anticipated direct and indirect costs and benefits resulting from proposed regulation. Furthermore, agencies would be prohibited from proposing any rule in which the quantified benefits did not exceed the quantified costs without a congressional waiver.

While perhaps not explicitly endorsing the FRRA, the foremost academic proponents of CBA for financial regulations have been the legal and economic scholars Eric Posner and E. Glen Weyl. Beginning with a 2013 article published in the American Economic Review, Posner and Weyl have strenuously argued that “to help ensure [that Dodd-Frank rulemaking] discretion is not abused, regulators should be required to use Benefit-Cost Analysis (BCA)” (Posner and Weyl 2013, p. 393). Posner and Weyl specifically had capital regulations in mind when devising their new administrative standard: “[s]tricter regulations, such as tighter capital adequacy standards or limits on the breadth of activities institutions can undertake slow the circulation of credit and liquidity. However, they also tend, at least when properly designed, to reduce the change of both individual bank failures and systemic crises” (Posner and Weyl 2013, p. 393). For Posner and Weyl this amounts to the relatively uncontroversial (in their view) notion that financial regulators should be held to the same standard as their environmentally-minded brethren: regulations should only be approved when they can demonstrate positive net present social value. They speculate that the costs of any such regulation “will usually be straightforward to calculate,” and venture to guess that a cost estimate for financial crises range somewhere between 150 billion and 4 trillion dollars “would seem relatively easy to reach” (Posner and Weyl 2013, p. 394).

In a longer paper published later the next year, Posner and Weyl expanded upon the institutional framework stated analytically in their short “Papers and Proceedings” article. According to the authors, “BCA would seem more appropriate for financial regulation where data are better and more reliable and where regulators do not confront ideologically charged valuation problems like those concerning mortality risk and environmental harm” (Posner and Weyl 2014, p. S2) (emphasis added). In contrast to the overwhelming majority of legal academics writing at the time, Posner and Weyl sought to defend the Business Roundtable court, declaring that “the bottom line is that the SEC did not monetize the expected benefits and costs of the rule and therefore had no basis for claiming that the rule complied with a BCA and hence served the public interest” (Posner and Weyl 2014, p. S9). The implications of such a statement are indeed profound; under Posner and Weyl’s framework a proposed regulation can only be in the public interest if capable of passing a court-approved and empirically founded CBA analysis.

Posner and Weyl’s articles engendered a flurry of academic responses, including a devoted issue in the Journal of Legal Studies. While the majority of responses were ultimately critical of the PW position, at least at its strictest conception, the replies fell somewhere on a spectrum from outright dismissiveness to sympathetic non-persuasion. On the more sympathetic end was John Cochrane, a conservative financial economist formerly of the University of Chicago and now residing at the Hoover Institution. Cochrane is an outspoken pundit when it comes to regulatory issues, including a much-discussed Wall Street Journal opinion piece linking post-recession anemic growth to regulatory headwinds. In Cochrane’s view “financial regulation routinely imposes costs far in excess of its benefits . . . financial regulation, like all economic regulation, desperately needs a better process for its enactment and periodic reevaluation than current institutions provide” (Cochrane 2014, p. S100). The problem for Cochrane is not with the diagnosis, but with the remedy: estimating quantified costs and benefits is not nearly as straightforward as Posner and Weyl make it appear.

First, Cochrane notes how estimating the effects of financial regulations differs fundamentally from those of environmental policy—financial policy is consumed with “[b]ehavioral, microeconomic, and macroeconomic responses . . . [which] are hard-to-quantify secondary effects” (Cochrane 2014, p. S65). These secondary effects are particularly pronounced in finance because it deals with “general equilibrium responses” and the pernicious effects of “fire sales, liquidity spirals, bubbles, predatory lending, and systemic stability” (Cochrane 2014, p. S68-69). While acknowledging the dearth of good academic work on CBA, and the need to jumpstart such an agenda, focusing on financial regulation “seems the hardest place to start the project of subjecting economic regulation to cost-benefit procedures” (Cochrane 2014, p. S69). Cochrane also takes umbrage with Posner and Weyl’s estimate of the cost of financial crises, noting that (i) the range on their estimate is huge; (ii) the estimate is subject to significant qualifications; and (iii) it is in no sense “relatively easy”, certainly not for a sitting generalist district court judge, to assess the plausibility of such an estimate (Cochrane 2014, p. S74). Cochrane also explains how the sole positive policy consensus to develop after the wake of the financial crisis—the consensus for increased capital adequacy ratios—was the result of “the compelling economic logic of Admati and Hellwig (2013), and the lack of much logic on the other side,” not robust empirical evidence (Cochrane 2014, p. S97). According to Cochrane “We should enact regulations only if their benefits exceed their costs. That seems obvious. But that’s not the point.” (Cochrane 2014, p. S63).

Another academic and policymaker fundamentally sympathetic to the role of CBA in policy analysis is Cass Sunstein, a Harvard Law professor and former administrator of the OIRA under President Obama. Sunstein, who has long been a proponent of CBA in the administrative state, acknowledges however that there are instances where quantification is impossible. In such a situation Sunstein proposes the adoption of “break-even analysis,” wherein agencies determine “how high would the benefits have to be for the regulation to be justified” (Sunstein 2014, p. 1372). In addition, Sunstein concedes that there are instances where break-even analysis should be non-applicable—for example, when we are considering the protection of fundamental rights “deontological constraints matter.” Speaking specifically to regulations designed to reduce the risk of a financial crises, Sunstein proposes the following thought experiment. If the rule were to cost (to whom is left unmentioned) $5 billion and the benefit of avoiding a financial crisis was $1 trillion, the agency could simply analyze whether the probability of avoiding a crisis was sufficiently large to satisfy the simple arithmetic constraint (Sunstein 2014, p. 1393-94). This obviously presupposes that any of these three figures—cost, benefit, and reduction in implied crisis probability—are estimable in a legally cognizable manner. Sunstein ultimately concedes that this rule may be inoperable in practice because “the range of possible costs can be very wide, and the range of possible benefits even wider, so much so that any effort to compare the two, or even to conduct breakeven analysis, might reflect a kind of pretense to knowledge that regulators simply lack” (Sunstein 2014, p. 1403).

Another modestly receptive commentator for the argument of CBA for financial regulations is Robert Bartlett, a law professor at UC Berkeley. Bartlett notes how each major financial regulator has already adopted some form of CBA process as a key component of their regulatory analysis, even though they have been effectively legally immune from such a requirement (Bartlett 2014, p. S379). He finds reason to believe that “subjecting all financial regulators’ CBA to an interagency review process may also help financial regulators grapple with oft-noted difficulties of quantifying the costs and benefits of financial regulation, which would enhance the accuracy of the resulting analysis” (Bartlett 2014, p. S400). According to Bartlett, while existing proposals to enact more rigorous CBA “may not yield the type of quantified uniform analysis that their proponents desire, they do contemplate a uniform system of institutional oversight of financial regulators’ CBA” (Bartlett 2014, p. S394). Specifically in relation to financial regulations, Bartlett concedes that inherent complexity may render formal CBA computationally impossible and advocates for a uniform system of CBA that requires “merely conceptual, nonquantitative CBA that was not subject to judicial review” (Bartlett 2014, p. S395). It becomes difficult to understand how this relaxed form of CBA analysis differs in any fundamental way from a governmental norm of “administer better,” and is certainly different in kind from the Crapo, Posner, and Weyl requirement for quantified CBA.

On the other end of the spectrum are two legal scholars, Jeffrey Gordon and John Coates, who find the Posner and Weyl proposal to be not only conceptually intractable but theoretically and politically misguided. For Gordon, a noted legal scholar out of Columbia University, CBA for financial regulation is a “serious category mistake” that has the potential to “stymie regulation aimed at the reduction of systemic risk in favor of privileging a status quo that we know is unstable” (Gordon 2014, p. S352-53). Gordon’s attack on financial CBA is primarily theoretical—“for any nontrivial problem it is conceptually wrongheaded, empty . . . as its core metaphor BCA has an omniscient social planner who can calculate costs and benefits from a system that is essentially stable, because the natural constraints are themselves stable” (Gordon, p. S352). His criticism is similar in vein to Cochrane’s skepticism—Posner and Weyl are attempting to impart a standard used for the natural sciences to the social sciences; a transition for which it is particularly unsuited.¹ While environmental regulations deal primarily with physical sciences, where the toxicity of a chemical or health effects of a proposal do not change for a given regulatory action, the financial system generates costs and benefits that flow directly from the financial regulation itself and the “subsequent process of adaption and regulatory arbitrage” (Gordon 2014, p. S352). Attempting to quantify the costs and benefits of a proposed regulation in a system with cascading second order effects is simply an ontological impossibility.

At a more practical level, Gordon argues that the effect of imposing CBA on financial regulations will be obstruction by vested interests and the continued inefficacy of much-needed reform. The nature of “hard-look judicial review” essentially guarantees that there will be “relitigation of empirically contestable conjectures” that will inevitably stall the reform process (Gordon 2014, p. S353). In its place, Gordon calls for critical judgments on financial matters to be made not on the basis of CBA, “but rather in light of normative principles that the regulator is prepared to defend as undergirding a sound financial system and that may be in competition with one another” (Gordon 2014, p. S374). Using the example of bank stress tests, Gordon shows how a normatively grounded and ostensibly subjective standard can allow regulators to make rolling modifications that avoid the issues of inherent stationarity implicit in conventional CBA.

I wrap up my survey of the literature (while noting that this review is by no means exhaustive), with the analysis of John Coates, a Harvard Law professor with a research focus on securities. In addition to sharing Cochrane and Gordon’s skepticism of the ability of empirically minded lawyers and judges to calculate and interpret, even asymptotically, the required costs and benefits of CBA, Coates focuses on the legal and practical implications of such a policy. First, he demonstrates methodically the risks of increased judicial activism in the area of financial regulatory policy, with a particular emphasis on the D.C. Circuit Court of Appeals–the court with primary jurisdiction over regulatory agencies. Beginning in the early 2000s, business trade groups invested considerable time and resources to persuade the D.C. Circuit to strike down rules under the APA arbitrary and capricious standard, even though there exists no such statutory requirement. The relative success of these attempts has essential hinged on another arbitrary practice—the random selection of panelists pulled from a sample of conservative and liberal jurists. As a result, when a business interest group is fortunate enough to be assigned a majority conservative panel they find a receptive audience. This culminated in the 2011 decision Business Roundtable, where a majority conservative panel found an SEC proxy-access rule—which had been congressionally mandated in the Dodd-Frank Act—to be arbitrary and capricious. According to Coates: “In sum, the D.C. Circuit’s new interpretation of the APA and the statutes authorizing financial regulation have permitted panels to overturn regulatory changes on the ground that a court would have conducted its guesstimated CBA differently than an agency would” (Coates 2015, p. 920).

In addition to documenting the consequence of privately funded demands for CBA in federal court, Coates painstakingly analyzes how the proposed CBA rule would affect the prospects of four notable regulatory actions. In particular, he analyzes how the Sarbanes-Oxley control disclosures, SEC mandate for independent boards at mutual funds (which he opposes), Volker Rule, and capital adequacy regulations would fare when subjected to Posner and Weyl’s conception of strict quantified CBR (Coates 2015, pp. 927-978). In each instance he documents the myriad assumptions, stipulations, and “guesstimates” that would go into conducting such an analysis, and expresses disbelief in the ability of a nonspecialized court to adjudicate the merits of the competing assumptions. This should give us all pause for concern. If the Posner & Weyl rule doesn’t work in the easy case—as Cochrane notes there is now near unanimity within the economic community on capital requirements—then it’s unclear what useful purpose it would serve.

In addition to the reservations expressed by those above, there are additional concerns that have been heretofore insufficiently addressed. First, while Cass Sunstein’s “breakeven analysis” would appear to be a sensible middle ground between warring parties, it is unlikely to be of any help in the truly difficult cases we’re concerned with. The problem is that, as other have observed, it is both the cost and benefits of proposed regulations that are often incapable of estimation. In those instances, breakeven analysis is of little use because both estimating parameters are unmoored, leaving us in a similar terrain of subjective governance. In addition, we should think long and hard about treating industry costs as societal costs. The discussion above has rationalized the comparison of societal costs and benefits without investigating further whether we should be as concerned with losses born from an industry that fails to take necessary precautions. While in environmental suits or product liability litigation we might assume costs will be extended to consumers, this assumption is potentially violated in the area of capital adequacy regulation. Finally, we should also be concerned about only analyzing CBA costs as of the present date. Even were we to assume massive current industry expense associated with increasing capital ratios, such a standard creates path-dependent incentives for industry-aligned groups to get capital levels as low as possible in order to argue the existence of exorbitant adjustment costs.

If it isn’t apparent from the tone of the prior commentary, I find the arguments put forward by respondents to be much more persuasive than the proposal of Senator Crapo, Eric Posner, and E. Glen Weyl. Certainly we all desire, and as a nation should aspire to, regulatory consistency and the adoption of rules and standards that tend in the limit to benefit society. No one of any merit truly argues to the contrary. The problem is that Posner and Weyl impute a level of technical competence and sophistication to the economics profession (let alone underpaid agency staff) that is unwarranted and potentially not achievable even in theory. This is the inherent quandary of social science; without the presence of truly random experiments we are forced to divine cause and effect from noisy measures found in daily life. Where a biologist can explain with approximate certainty the ramifications of the introduction of a chemical substance, economists are historically “two-handed”, couching predictions on secondary effects with substantial cautionary language. Were this simply an interesting academic exercise it wouldn’t merit our attention. But vested interests and their high-priced legal teams understand this inherent friction, and will use it as cudgel to forestall reform in the nation’s interest if given the opportunity.

1. Bartlett III, Robert P. 2014. “The Institutional Framework for Cost-Benefit Analysis in Financial Regulation: A Tale of Four Paradigms?” Journal of Legal Studies 43 (2014): S379-S405.
2. Coates IV, John C. 2015. “Cost-Benefit Analysis of Financial Regulation: Case Studies and Implications.” Yale Law Journal 124: 882-1011.
3. Cochrane, John H. 2014. “Challenges for Cost-Benefit Analysis of Financial Regulation.” Journal of Legal Studies 43: S63-S105.
4. Gordon, Jeffrey N. 2014. “The Empty Call for Benefit-Cost Analysis in Financial Regulation.” Journal of Legal Studies 43: S351-S378.
5. Posner, Eric and E. Glen Weyl. 2013. “Benefit-Cost Analysis for Financial Regulation.” American Economic Review: Papers and Proceedings 103(3): 393-397.
6. ––––––––––– 2014. “Benefit-Cost Paradigms in Financial Regulation.” Journal of Legal Studies 43: S1-S33.
7. ––––––––––– 2015. “Cost-Benefit Analysis of Financial Regulations: A Response to Criticisms.” Yale Law Journal Forum 124 (2015): 246-262.
8. Sunstein, Cass R. 2014. “The Limits of Quantification.” California Law Review 102(6): 1369-1422.