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.
Posts Tagged ‘Cost-benefit analysis’
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.
As you may know, the SEC has recently enhanced its economic firepower, through, for example, significantly increasing the number of PhD economists in the Division of Risk, Strategy, and Financial Innovation. Lately much of the external focus on the role of economic analysis at the SEC has been on cost-benefit analysis – which is certainly an important part of economic analysis. However, it is not the only way that the Commission is using economic analysis in our work. Increasingly, our economists are getting involved earlier and more comprehensively in the rulemaking process, not just to help the Commission weigh the ultimate costs and benefits of our regulatory decisions, but to provide a reasoned framework for making those decisions. Examples include providing up-to-date information about the current state of the markets, and helping us think of alternative ways to meet our regulatory goals.
I believe that these efforts are bearing fruit, and I would like to provide a recent example of a significant regulatory action where, in my view, we used economic analysis effectively to guide our decision-making. This was in our adoption of the rule defining “security-based swap dealer” under Title VII of the Dodd-Frank Act, as part of a joint rulemaking with the CFTC. Further defining the term “security-based swap dealer” was one of the many tasks that Congress assigned to us as part of creating a new regulatory regime for security-based swaps. Congress also mandated that the Commission exempt from the dealer designation an entity that engages in a de minimis quantity of dealing activity. Again, however, Congress left it to us to hammer out the details of what would constitute a de minimis level of dealing activity. Considering that the over the counter derivatives market is still a largely unregulated space, determining an appropriate de minimis level seemed like a daunting task, and the comments we received reflected a diversity of views on what this de minimis level should be.