Four years after the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), the use of cost benefit analysis (CBA) in financial regulation has come to play a critical role in an increasingly heated debate concerning the statute’s implementation. Requiring nearly three hundred rule-makings across twenty agencies, Dodd-Frank’s enormous regulatory mandate represents for many an especially dangerous risk of the typical “drift” and “slack” problems long associated with administrative rule-making. The fact that Dodd-Frank was enacted in the midst of an economic recession only heightens these fears, particularly the concern that overworked and/or overzealous agencies might discharge their regulatory mandate by promulgating cost-insensitive regulations. In light of these concerns, a number of Congressional proposals now exist that would subject financial rule-making to more formal CBA reflecting the conventional belief that rigorous CBA can provide much-needed accountability over regulatory agencies.
Posts Tagged ‘Cost-benefit analysis’
The incentive to take socially costly financial risks is inherent in banking: because of the interconnected nature of banking, one bank’s failure can increase the risk of failure of another bank even if they do not have a contractual relationship. If numerous banks collapse, the sudden withdrawal of credit from the economy hurts third parties who depend on loans to finance consumption and investment. The perverse incentive to take financial risk is further aggravated by underpriced government-supplied insurance and the government’s readiness to play the role of lender of last resort.
“Mandated disclosure may be the most common and least successful regulatory technique in American law.” Thus opens our book, More Than You Wanted to Know: The Failure of Mandated Disclosure (Princeton Press, 2014).
Of mandated disclosure’s triumph there is no doubt. This blog’s readers see it everywhere. Corporate scandals and financial crises ceaselessly spawn new disclosure laws: the Securities Act of 1933, the Truth-in-Lending laws of the 60s and 70s, Sarbanes-Oxley in 2002, and, recently, Dodd-Frank. Disclosure pervades tort law (“duty to warn”), consumer protection (“truth in lending”), bioethics and health care (“informed consent”), online contracting (“opportunity to read”), food law (“nutrition data”), campaign finance regulation, privacy protection, insurance regulation, and more.
This triumph is understandable. Mandated disclosure aspires to help people making complex decisions while dealing with specialists by requiring the latter (disclosers) to give the former (disclosees) information so that disclosees choose sensibly and disclosers do not abuse their position. It is seductively plausible. (Don’t people make poor decisions because they have poor information? Won’t they make good decisions with good information?) It alluringly fits all ideologies. (Thaler and Sunstein like it because it is “libertarian paternalistic”; corporations would “rather disclose than be regulated”). So mandates are enacted unopposed. Literally.
The 2010 Dodd-Frank Act mandated over 200 new rules, bringing renewed attention to the use of cost-benefit analysis (CBA) in financial regulation. CBA proponents and industry advocates have criticized the independent financial regulatory agencies for failing to base the new rules on CBA, and many have sought to mandate judicial review of quantified CBA (examples of “white papers” advocating CBA of financial regulation can be found here and here). An increasing number of judicial challenges to financial regulations have been brought in the D.C. Circuit under existing law, many successful, and bills have been introduced in Congress to mandate CBA of financial regulation.
Nearly all U.S. regulatory agencies use benefit-cost analysis (BCA) to evaluate proposed regulations. The EPA, for example, uses BCA to evaluate regulations that require factories to reduce emissions. OSHA uses BCA to evaluate regulations that require workplaces to install safety devices for workers. NHTSA uses BCA to evaluate fuel economy standards. Yet a striking exception to this pattern occurs in the area of financial regulation. The major agencies with jurisdiction over financial activities—including the SEC, the CFTC, and the Fed—have almost never used formal BCA to evaluate financial regulations.
Yet there is no reason to believe that BCA would be appropriate for environmental or workplace regulation and not for financial regulation. Indeed, 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. The benefits and costs of financial regulation are commensurable monetary gains and losses, and so can be easily compared.
While much has been published on the business case for sustainability during the last decade, businesses have been slow to adopt the green innovation and sustainability agenda. Reasons include a lack of consistency in the indicators employed by analysts, and a failure to effectively incorporate financial value drivers into the equation. This article defines a green business case model that includes seven core financial value drivers of special interest to financial analysts.
Researchers, management experts, and activists have published extensively over the last decade on the business case for sustainability. The accumulated evidence and experience makes it clear that sustainability actions do not have a negative or neutral impact on the financial performance of a business. Rather, it is a question of the degree to which sustainability actions have a positive impact on financial performance. One research overview has identified more than 60 benefits, clustered into seven overall business benefit areas.
As greater attention is paid today to integrated thinking and more sustainable business models, the link between sustainability actions and corporate financial performance remains central. However, the business case evidence collected to date has failed to have the expected scale of impact. One reason for this is the lack of consistency in indicators employed by analysts in their examination of possible cause and effect relations. Another is the gap in discipline between sustainability experts and financial officers, with each community conversing in its own language (jargon). Sustainability activists have failed to get a better grasp on corporate finance, while financial officers have failed to get a better grasp on the sustainability agenda.
The mission of the SEC is both straightforward and broad: To protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Though none of these objectives exists in isolation-and indeed, they interact and reinforce each other-today I thought I would focus on our primary mission of protecting investors. Specifically, I would like to discuss the role of economic analysis in furthering the Commission’s mission to protect investors and how the public can help the Commission craft regulations that effectively accomplish that goal.
Economic Analysis in Support of Commission Rulemaking
The Division of Risk, Strategy, and Financial Innovation (or “RSFI”) supports the Commission in a variety of ways, but the one that perhaps most directly impacts the investing public is the Division’s role in providing economic analysis in support of Commission rulemaking. And I believe that the economic analysis provided by RSFI is one of the essential elements of how the Commission works to fulfill its mission to protect investors.
In Business Roundtable v. SEC, the DC Court of Appeals struck down the proxy access rule giving certain shareholders access to the corporate proxy on the grounds that the SEC failed to adequately fulfill its requirement to consider the impact of new rules on “efficiency, competition, and capital formation.” The Court offered a blistering critique of the SEC’s economic analysis in the rule. Criticism of the opinion followed and also led to a series of Congressional hearings on the SEC’s process for weighing the economic costs and benefits of new rules. Many of the critics of the opinion, and indeed of cost-benefit analysis itself, have argued that it is simply too difficult to guide rulemaking, or that costs are easier to measure than benefits and so the approach trends against the status quo.
I counter that critique of Business Roundtable by way of example in an article co-authored with Thomas Stratmann in the Stanford University Law Review, Does Shareholder Proxy Access Damage Share Value in Small Publicly Traded Companies? We suggest a question the SEC might itself have investigated about its approach, if it had submitted a rule proposal first and if it was committed to economic analysis of its rules. We consider a natural experiment provided by the rule’s differential impact on small and large firms above and below the arbitrary $75 million market capitalization separation. We measure the impact of the market’s frustrated expectation of a permanent exemption for small firms, an expectation stemming from prior SEC implementation of other controversial rules and strong language in the Dodd-Frank Act, against a control group represented by large firms who expected application of the rule and for whom the new rule’s impact was largely capitalized into their value.
In the past few years, several important financial regulations have been struck down by the D.C. Circuit Court of Appeals because the regulatory agency failed to prove that the benefits of those regulations exceeded the costs. There is no current explicit legal requirement for financial agencies to conduct cost-benefit analyses, but given vagaries in the underlying statutes, the Court has felt that it has the authority to insist on a greater degree of economic rigor than agencies often display. In a parallel development, Senator Shelby has introduced a bill that would explicitly require financial agencies to perform cost-benefit analyses. If the bill is enacted, we will see even greater bloodshed in the courts.
In a recent paper co-authored with Connor Raso, I argued that D.C. Circuit’s Business Roundtable decision has set a very high bar for cost-benefit analysis in rulemaking by financial regulators like the SEC. In 2011, the court struck down the agency’s long-pondered proxy access rule—a rule expressly authorized by Dodd-Frank—and did so in a way that calls into question the practical ability of the SEC and other financial regulatory agencies with similar mandates to adopt future rules that will withstand timely challenge.
Our paper, Rational Boundaries for Cost-Benefit Analysis in SEC Rulemaking (forthcoming, Yale Journal on Regulation), analyzes the interplay of legislative, executive, agency and judicial actions over the last thirty years that led to this situation. We point out the contradiction between the Commission’s structure (bipartisan by statute and often requiring logrolling compromises to reach a result) and the assumption of global rationality that underlies cost-benefit analysis.