Cost-Benefit Analysis of Financial Regulation: Case Studies and Implications

John Coates is the John F. Cogan, Jr. Professor of Law and Economics at Harvard Law School.

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.

In this paper, Cost-Benefit Analysis of Financial Regulation: Case Studies and Implications, I develop detailed case studies that collectively show that precise, reliable, quantified CBA is simply not feasible in a representative sample of six significant financial regulations. Instead, efforts to quantify CBA routinely require multiple, subjective, contestable judgments, producing what can only be called “guesstimates”—extremely wide ranges of equally defensible net costs and benefits—so wide that the effort cannot meaningfully “guide” assessments of the rules. Because finance is central to the economy, because it is social and political, and because it is non-stationary, regulation of finance and financial markets is different in kind from many other kinds of regulation, which focus on activities that can be more reliably studied. As a result, judicial review of quantified CBA in the financial context is more likely to camouflage discretionary choices than to discipline agencies or promote democracy.

The paper first clarifies the meaning of CBA. CBA is often used to mean policy analysis, but also to mean types of laws mandating the use of CBA or providing for judicial review of CBA or its inputs. CBA is also sometimes used to describe a general conceptual framework for evaluating regulations, roughly amounting to applied welfare economics, which is a sensible framework for general policy analysis, but it is also sometimes expected to produce specific quantified estimates of the effects of a rule—“quantified CBA.” Finally, CBA is often viewed as a clearly good thing as a policy matter—enhancing transparency and democracy, and disciplining regulators—but the history of CBA suggests that it can also produce a darker mix of effects, including rent-seeking, increases in regulatory discretion, and reductions in transparency. The paper then reviews current law of CBA relevant to financial agencies, and critiques the recent spate of D.C. Circuit decisions striking down regulations on the supposed ground of inadequate CBA.

The core of the paper is a close examination of what efforts to quantify CBA might produce, or in two cases what such efforts did produce, as applied to six representative and major financial regulations:

  • 1. The SEC’s disclosure rules under Sarbanes-Oxley Section 404,
  • 2. The SEC’s aborted mutual fund governance reforms,
  • 3. Basel III’s heightened capital and liquidity requirements for banks,
  • 4. The Volcker rule,
  • 5. The SEC’s cross-border swap proposals, and
  • 6. The FSA’s mortgage market reforms.

In the case studies, the paper attempts to advance the substantive project of quantitative CBA of financial regulation itself, by specifying in more detail than prior research how CBA could be applied in specific contexts, and by more carefully describing, clarifying, and specifying sources of sensitivity of the results of quantified CBA in each study. The primary general conclusion of the case studies is that CBA of such rules cannot be reliably and precisely quantified with current research methods.

Rather, CBA for major financial regulations entails (a) causal inferences that are unreliable under standard regulatory conditions; (b) using problematic data, and/or (c) the same contestable, assumption-sensitive macroeconomic and/or political modeling used to make monetary policy, which even CBA advocates would exempt from CBA law. While CBA is a useful conceptual framework for financial regulation, and quantified CBA is a worthy long-term research goal, CBA is not capable of disciplining regulatory analysis in its current state. Instead, CBA should be conducted only to the extent the relevant financial agencies choose to do so. For the near future, at least, decisions of when and how to conduct CBA in the financial regulation inevitably remain in the realm of judgment—and subject to ordinary political discipline. Neither Congress nor the Courts can force such decisions into the realm of science, and attempts to do so will be more political than legal, and do more to obscure than enlighten the public about the judgments financial regulation requires.

The full paper is available for download here.

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