Benefit-Cost Paradigms in Financial Regulation

The following post comes to us from Eric Posner, Kirkland & Ellis Distinguished Service Professor of Law and Aaron Director Research Scholar at the University of Chicago, and E. Glen Weyl, Assistant Professor in Economics at the University of Chicago.

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.

There are legal and practical reasons for financial regulators to use BCA as well. In its Business Roundtable decision, the D.C. Circuit Court of Appeals struck down the SEC’s proxy access rule because it failed a benefit-cost test. And Senators Crapo and Colby have proposed a Financial Regulatory Responsibility bill, which would require financial regulators to conduct BCA on financial regulations. But the best reason for conducting BCA is that it is a tool of good government. BCA helps ensure that regulations advance the public interest and increases government transparency.

We recently invited leading financial economics and legal scholars to the University of Chicago for a conference on benefit-cost analysis of financial regulation. Our paper, Benefit-Cost Paradigms in Financial Regulation, summarizing the conference proceedings provides guidance to regulators for developing protocols or paradigms for financial BCAs. We argue that regulators should focus on four possible benefits from financial regulation: reduction in the risk of bailouts and financial panic; correction of capital misallocation; reduction of gambling; and protection from misallocation of investments by consumers. All of these benefits can be quantified, although further research will be necessary before we have reliable estimates of most of them. A financial regulation survives a BCA if the benefits it produces are greater than the costs, which can usually be measured in terms of lost profits by affected financial institutions.

Much work remains to be done. But once financial regulators commit to using BCA, we can expect economic consultants to offer their services, and help refine the methodologies for measuring the benefits and costs of financial regulations. This is what happened with health, safety, and environmental regulation, and history should repeat itself for financial regulation as well.

The full paper is available for download here.

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