I would like to talk about economic analysis in support of Commission rulemakings, and, in particular, the role of economists from the Division of Risk, Strategy, and Financial Innovation (or “RSFI”) and the recently issued guidance on economic analysis.
Background on the Division of Risk, Strategy, and Financial Innovation
Without going into a description of the history of RSFI — which would not take long in any event, as the Division is only three years old — it may be useful to set the stage for how, in my mind, the Division fits into the overall structure of the Commission.
First, who are we? Often referred to as the SEC’s “think tank,” RSFI consists of highly trained staff from a variety of academic disciplines with a deep knowledge of the financial industry and markets. For example, we currently have over 35 PhD financial economists on staff, and hope to hire more this fall. We also have statisticians, financial engineers, programmers, MBAs, and other experts, including individuals with decades of relevant industry experience.
Second, what do we do? While the Division is involved in an incredibly broad range of issues across the Commission, the majority of our staff and our time is dedicated to performing two significant functions: First, quantitative research and risk assessment, and second, economic analysis in support of Commission rulemaking. This is not to say we do not serve a variety of other functions. For example, we have a strong group of economists and experts who support the Division of Enforcement by, among other things, estimating the amount of ill-gotten gains and providing critiques of expert witness testimony. We also parachute in to assist Divisions if there are breaking events in the markets, providing data analysis and other technical expertise.
Because of our involvement in a variety of projects across Divisions and Offices, RSFI staff is required to be very creative and I believe that the Division approaches regulatory issues with a uniquely broad perspective. Moreover, RSFI is closely involved with parties and issues outside of the SEC. For example, we work with outside industry and academic experts to inform the Commission about current market trends and innovations and their potential impacts on financial regulation. And significantly, my staff pursues active research agendas, including contributing to peer-review publications and regularly participating in industry conferences, to remain engaged with current research methods and to maintain our expertise in cutting edge approaches and methodologies.
Economic Analysis Guidance
I’d like to focus on one area of the Division’s work in particular — economic analysis in support of Commission rulemaking. Of course, RSFI and before us, the Office of Economic Analysis, has always been involved in assisting the Commission to evaluate the potential economic effects of its rules. But since I joined the Division a little over a year ago, I have seen a steady evolution — led by our Chairman — in how the Commission and the Staff approaches the entire rule development process. Economic analysis really is an integrated part of the policy conversation and I believe that is reflected in the rule releases put out by the Commission.
As some of you may be aware, in March of this year, at the direction of the Chairman, RSFI and the Office of the General Counsel circulated to the rulemaking Divisions and Offices of the Commission a document that provides guidance on how the Staff should approach economic analysis. This document, affectionately called “the Guidance,” provides a high-level approach to economic analysis, drawing on concepts from various sources, including guidance issued by the Office of Management and Budget, congressional correspondence, studies performed by our own Inspector General, as well as various court cases. It provides a road map for Staff to follow both to ensure that economic analysis is integrated throughout the entire rule development and writing process, as well as the concepts that the analysis should cover.
Given that many of you in this room, as well as my hosts, submit comments to the Commission regarding various rules, I thought I would take some time to provide a quick overview of the major topics covered by the Guidance. But before I go into more detail and provide a few examples of the kinds of analyses I’m talking about, I think we need to step back and define a few relevant terms. Specifically what is the difference between what I’ve focused on — economic analysis — and another phrase you might hear a lot, “cost-benefit analysis.”
Economic analysis, as defined at a very high level, is the consideration of the potential economic effects — i.e., effects on the market — of the SEC’s policy choices. Given this broad definition, cost-benefit analysis is only one aspect of economic analysis. Similarly, in many rulemakings the Commission is required to consider the rule’s effect on the promotion of efficiency, competition, and capital formation or to consider the rule’s burden on competition. This, again, is part of the wider effort to consider the economic effects of the SEC’s actions. Because I’m not an attorney, I won’t speak to what our particular legal obligations are under the securities laws or the Administrative Procedure Act. Rather, from an economist’s point of view, I believe that the Guidance reflects a common-sense approach to being thoughtful and transparent about economic analysis, including the potential impacts and trade-offs of the regulatory decisions that the Commission is making.
The Guidance is available on the SEC website and I certainly encourage everyone who submits comment letters to the Commission or pays attention to our rules to read it at some point. It reflects a huge amount of work from staff in my Division, the Office of the General Counsel, as well as input from across the agency. But I will highlight a few of the major topics covered by the Guidance.
The Guidance lays out a general approach to rulewriting to ensure that economists are involved at each step of the rule development process, from the policy development stage — before a release is even drafted — up through final adoption. While, again, economists have always been involved in the rulemaking process, our explicit inclusion of economists at each step has led to even more extensive collaboration between my staff and the staffs of other Divisions and Offices that I believe has strengthened our rules. The majority of the Guidance, however, focuses on providing general principles to guide staff — both within my Division and others — as to the substantive elements of a robust economic analysis.
Elements of an Economic Analysis
The Guidance lays out four basic elements of a robust economic analysis: identifying the need for the regulatory action; defining the baseline against which to measure the economic effects of that regulatory action; identifying alternative regulatory approaches; and, finally, an evaluation of the benefits and costs of the regulatory action and the principal regulatory alternatives, both quantitative and qualitative.
So of course the first step in developing a rule is to identify why we need a regulation in the first place. This may seem to be an obvious first step, but it is important to ensure that we pause to truly consider this question. We must define our goals so that we can then thoughtfully examine the various avenues that are available to us. This can be more difficult than it sounds. Sometimes it can be clear, as with a specific market failure that cannot be solved without regulatory intervention. Other times — as we see with the Dodd-Frank Act and the JOBS Act — Congress has identified a problem for us and directed us to engage in rulemaking to address it. In that case, the justification for why regulation is necessary can be something as basic as, “Congress told us to.” But in other cases, identifying why regulation is needed and exactly how significant a problem is — or even whether a problem exists at all — can be very much a matter of debate.
Once we’ve settled on the need for the regulation, the Guidance tells us to develop a full understanding of what the world looks like in the absence of that regulation, i.e., the baseline. This baseline analysis is the benchmark against which to measure the potential economic effects of the rule. But even more than that, I think the baseline analysis is an important way to make sure that the public understands the Commission’s view of the world as it regulates. For example, a few months ago the Commission put out a final rule that laid out, amongst other things, the procedures under which a registered clearing agency would submit for Commission review any security-based swap the agency plans to accept for clearing. In the Economic Analysis, the Commission explained that these process rules were being adopted against the background of substantive reforms to the system of clearing securities. As a result, the rule release laid out, at a high level, a description of current voluntary clearing activity, including some new statistics about the market generated by Commission staff. This type of transparency not only helps the Commission understand the backdrop against which it is regulating, but also allows the public insight into the information that is animating the Commission’s actions so that the public can evaluate and respond to the Commission’s views.
Once we’ve defined the regulatory goal and the background against which that goal exists, the Commission must then decide what the best way to accomplish that goal is. Here, the Guidance is clear that Commission releases must identify reasonable alternative ways to reach that outcome. As did the Guidance, I have chosen my words carefully. The Commission need consider only reasonable alternatives. Thus, we need not engage with any alternative that would, for example, be forbidden by the law, or that is not technologically possible. And, when the Commission adopts a rule, the rule release must articulate why the Commission chose the alternative it did, fully engaging with those reasonable alternatives raised in the proposing release or suggested by commentators.
From my point of view, I think this can be one of the more fun aspects of developing a rule. (As an aside, when this can be considered fun, it is indeed a sad statement about the mindset of a practitioner of the “dismal science.”) Brainstorming various alternatives or asking questions about variations that could be made to the primary regulatory proposal are a particularly interesting way for economists in RSFI to contribute to the work of developing a rule proposal. It might sound like a truism, but economists and lawyers can look at the world differently. The search for alternatives can be a particularly dynamic area for their different skill sets and knowledge bases to come together. Similarly, when commentators submit alternatives during the comment process, economists can assist in evaluating the potential market impacts of those alternatives, and helping to determine whether those options will meet the regulatory goals originally defined by the Commission.
Finally, we get to the heart of the matter: the evaluation of the benefits and costs of the rule. Part of understanding the trade-offs of a particular regulatory approach is to discuss the benefits and costs of that action. The Commission, of course, historically has evaluated the benefits and costs of its rules, but it is important to seriously consider how this analysis should unfold.
There has been much recent attention paid to quantifying benefits and costs. But focusing primarily on quantification — while an important consideration — puts the cart before the horse. The first, and most important step, is to develop a general framework of benefits and costs that are relevant to the rule. This general framework should be entirely qualitative and address direct benefits and costs, as well as significant ancillary economic consequences. Only once this framework has been developed should we move on to quantification. Only those benefits and costs that can reasonably (there’s that word again!) be quantified should be.
Then, finally — and I think this is really the most important step of the evaluation of the benefits and costs of a rule — we should step back and consider the mosaic created by our analysis and identify any gaps. We should be transparent about why certain benefits and costs cannot be quantified, for example, because data is not available that would allow for reasonable estimation of benefits and costs. We should identify and discuss uncertainties about estimates. Perhaps we had to analogize to another regulatory area to develop a quantified estimate. In that case, we should be clear about the differences between the two regulatory areas and the impacts those differences could have on the accuracy of the estimates. And crucially, we should clearly address contrary data or predictions. When contradictory evidence regarding the benefits and costs of a regulatory action exists, we must evaluate that evidence, and if giving greater credence to one side, explain why.
A vital part of this entire effort to analyze benefits and costs is to be transparent and even-handed when describing potential costs, even if they are high. Nothing prevents the Commission from adopting a fully-considered rule that has high costs. Indeed, sometimes, short-term costs are necessary to prevent future, more significant costs, or compliance costs must be imposed to protect investors or the broader market. But that does not mean that those costs should be concealed. In all cases, I believe it is better to present and evaluate the benefits and costs neutrally and consistently.
That said, it can be a significant challenge to develop an analysis that fairly conveys the potentially significant benefits of regulatory action when, as can often occur, it is easier to develop quantified estimates of costs than of benefits. Thus, the Commission can face a situation in which the costs of a regulatory action seem to “outweigh” the benefits because the benefits cannot be quantified. This does not mean that the costs should not be quantified, or that the Commission should not make those potential costs public in a rule release. But to return to my fundamental approach to cost-benefit analysis I explained earlier, that is why I believe that the initial articulation of the qualitative framework for benefits and costs is so important. This broad, qualitative view of all economic benefits and costs places any quantified benefits and costs into a broader context and, hopefully, prevents any particular benefit or cost from taking on unjustifiably outsized significance.
The Role of Data Analysis
I’d like to switch gears and dig down a little more into the distinction I drew earlier in this talk between cost-benefit analysis and economic analysis more broadly. While assisting with the quantification of benefits and costs is an important function for my economists, I think that one area in which my Division is significantly impacting the rulemaking process is in the enhanced use of data analyses.
Perhaps to state the obvious, there are going to be economic effects of a regulatory choice that cannot be captured as a “benefit” or a “cost.” For example, take a simple threshold analysis. In many Commission rules, a decision must be made about where to set a particular threshold, say for example, defining who should be included in the ambit of a regulatory definition and who should not. It is only once a threshold is selected that a cost-benefit assessment can be undertaken. (For example, what are the costs if the definition is too broad and too many entities are included in the scope of the regulation? What are the benefits to including certain activities within a regulatory definition and thus subjecting them to enhanced oversight?) But how can the threshold be set in the first place? Developing a framework within which to choose one can require significant data analysis to determine the scope and distribution of those entities that could be captured by different cut-offs.
Here’s an example to make this discussion less abstract. In April of this year, the Commission adopted a rule further defining “security-based swap dealer” and “major security-based swap participant” as required by the Dodd-Frank Act. Our economists analyzed voluminous amounts of transaction and position data to examine the amount of CDS dealing activity that would be covered — and likewise, the amount of dealing activity that would be unregulated — under various de minimis thresholds. My Division authored a memorandum laying out its analysis of the CDS data, along with the methodologies and assumptions underlying that analysis. This memo was then included in the comment file to ensure that our analysis was available to the public for review and comment. The analysis characterized the trading behaviors of entities participating in the CDS market with the goal of identifying market-making activity commensurate with that of a dealer. Ultimately, the analysis suggested that under a $3 billion de minimis threshold adopted in the final rule, at least 98% of CDS dealing activity will be covered under Title VII regulation.
This is just the tip of the iceberg of what the Commission can do with data. As I alluded earlier, we used CDS data to lay out some background information relevant to the Commission’s efforts to implement new mandatory clearing requirements as directed by the Dodd-Frank Act. And that analysis can be extended to other Title VII rule makings. For example, we can use data to identify the types of participants in the CDS market, the frequency of their participation, concentrations of risk, and how this risk travels across jurisdictional boundaries. All this information will be vital as the Commission continues implementing the Dodd-Frank Act in previously largely unregulated areas.
So what does this mean for you, who may comment on Commission rules? Moving forward, I expect the use of data to become an increasingly integrated part of our rulemaking process and I am committed to ensuring that my economists provide sophisticated and cutting-edge data analyses to the Commission to assist in policy development. In many cases, as in the examples I just gave, the Commission will submit these data analyses for public comment. Our goal is to be transparent about our methodologies, assumptions, and data sets and we hope that commentators will provide rigorous feedback on our analyses. But in some cases, the Commission may not have access to data that would be useful in assessing some of the potential impacts of our proposed rules. In those cases, we will have to rely on public comment to assist us. As I hope I’ve made clear, the Commission has many incredibly talented economists and other experts, and thus, we stand ready and prepared to evaluate data submitted by commentators regarding the Commission’s rules.
Facilitating a rigorous back-and-forth between the Commission and the public regarding the economic effects of the Commission’s rules may be one of the most important contributions of the Guidance. As I have described, each element of the Guidance promotes transparency in Commission rulemaking. We expressly identify the need for regulatory action, the Commission’s view of the current state of the world, alternative regulatory approaches, and the benefits and costs of the proposed action. This framework provides the public insight into exactly why and how the Commission is choosing to act, and the public then has the opportunity to respond to the Commission on each of these points.
As the Commission’s economic analyses are rigorous and transparent, I believe that the comment letters must rise to our standard. I strongly urge all those who submit comment letters to engage in the same thoughtful and difficult analyses that we are performing at the Commission. We rely on you not only to fill in gaps in our data, but also to submit our own analyses to careful scrutiny. I come from the rough-and-tumble world of academia where rigorous critiques of my work are par for the course. I not only expect it, but welcome it. But we will do the same to those analyses submitted to the Commission. Vague letters that speak of “heavy burdens” or “significant effects” are of course considered by the Commission, but they do not provide my economists with concrete data or categories of effects that they can then analyze. Similarly, sloppy analyses that fail to articulate their methodologies or assumptions will be evaluated with the clear eyes of the Commission’s expert staff. I hope that all parties — the Commission and stakeholders alike — wrestle with the difficult issues we are facing and work together to develop the strongest analyses possible.