The Importance of Cost-Benefit Analysis in Financial Regulation

Abstract

This report reviews the role, history, and application of cost-benefit analysis in rulemaking by financial services regulators.

For more than three decades — under both Democratic and Republican administrations — cost-benefit analysis has been a fundamental tool of effective regulation. There has been strong bipartisan support for ensuring regulators maximize the benefits of proposed regulations while implementing them in the most cost-effective manner possible. In short, it is both the right thing to do and the required thing to do.

Through the use of cost-benefit analysis in financial services regulation, regulators can determine if their proposals will actually work to solve the problem they are seeking to address. Basing regulations on the best available data is not a legal “hurdle” for regulators to overcome as they draft rules, as some have described it, but rather a fundamental building block to ensure regulations work as intended.

Not only do history and policy justify the use of cost-benefit analysis in financial regulation, but the law requires its use. In a trio of decisions culminating in its much-publicized 2011 decision in Business Roundtable and U.S. Chamber of Commerce v. SEC, the D.C. Circuit has interpreted the statutes governing the Securities and Exchange Commission (SEC) to require the agency to consider the costs and benefits of a proposed regulation. Thus, the SEC’s failure to adequately conduct cost-benefit analysis, the D.C. Circuit has held, violates the Administrative Procedure Act. These judicial decisions have supporters as well as critics. However, the SEC’s response is telling: the SEC did not seek further judicial review, but instead issued a guidance memorandum in March 2012 that embraced virtually all of the instructions the D.C. Circuit had provided in its decisions. It remains to be seen whether the SEC will put its new guidance memorandum into practice.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) only elevates the importance of cost-benefit analysis in financial regulation. By requiring nearly 400 rulemakings spread across more than 20 regulatory agencies, implementing Dodd-Frank is an unprecedented challenge for both regulators and regulated entities. The scale and scope of regulations have made it even more important, despite the short deadlines, for regulators to ensure they adequately consider the effectiveness and consequences of their proposals.

Accordingly, we recommend that all financial services regulators should follow similar protocols found in the SEC guidance memorandum and apply rigorous cost-benefit analysis to improve rulemaking and put in place more effective regulations. These steps also promote good government and improve democratic accountability.

There is widespread agreement that ineffective and outdated financial regulation contributed to the financial crisis. As regulators seek to address that, they must take every reasonable step to ensure that their proposals work. This starts with grounding all proposals in an economic analysis to better achieve the desired benefits and better understand the possible consequences and costs that may result from their actions.

Keywords: administrative law, financial regulation, cost-benefit analysis