The cost of fewer bank-induced recessions? Priceless.

Michael Nagle/Bloomberg

Warren's Wrong: Bank Rules Need Cost-Benefit Test

Eric A. Posner, a professor at the University of Chicago Law School, is a co-author of “The Executive Unbound: After the Madisonian Republic” and “Climate Change Justice.”
Read More.
a | A

A group of senators from both parties is on the verge of proposing legislation that would subject financial regulations to cost-benefit analysis. Senator Elizabeth Warren has already announced her opposition. But the idea is a good one, and deserves support from liberals and conservatives alike.

Cost-benefit analysis is a technocratic policy tool, akin to net-present-value methods used by businesses to evaluate investments. It is neither liberal nor conservative; it provides a method for calculating the effect of a proposed regulation on public well-being.

The approach for a long time suffered a bad reputation among liberals, no doubt because it was central to President Ronald Reagan's 1981 executive order to tame federal regulation. Critics then argued that Reagan sought to use cost-benefit analysis to block and delay needed rulemaking, and that cost-benefit analysis was biased against regulation because many benefits -- saving human lives, improving environmental quality -- were difficult to quantify.

However, every succeeding president, including Bill Clinton and Barack Obama, renewed Reagan’s executive order. It turns out that well-designed environmental, safety and health regulations can pass the cost-benefit test. The technique can be used to defend good regulations as well as block bad ones.

For this reason, some conservatives have soured on cost-benefit analysis. They have come to believe that it's too easy to manipulate by liberals who seek excessive regulation. This may well be true. While regulation issuance slowed during the Reagan administration, its steady march has continued.

Because cost-benefit analysis isn't mandatory, presidents can waive the requirement, and they often do. If you read the cost-benefit analyses that agencies have issued (I’ve done it so you don’t have to), you’ll see that they often refrain from quantifying benefits. Nonetheless, the cost-benefit executive orders have made a difference. It’s much easier to understand why agencies regulate today than it was 40 years ago, and that means it’s easier to argue with them and challenge them in court.

The executive orders don't apply to independent financial regulatory agencies which, for the most part, haven't conducted cost-benefit analyses. A few years ago, the Washington, D.C., appeals court struck down a corporate governance rule that the Securities and Exchange Commission had issued. The court believed the costs didn't justify the benefits, upsetting a great number of reformers.

To be fair to the critics, the court didn't have a clear statutory mandate for its ruling, and caught the SEC off guard. The court also wasn't sensitive to the difficulties of conducting cost-benefit analysis of financial regulations, which requires judgment, not just a mechanical application of an algorithm.

Some academics go farther and argue that cost-benefit tests for financial regulation are impossible. They think it’s too difficult to predict the effect of a regulation on the financial system. You might think that if the government has no idea what effect an expensive regulation will have on the economy, it should refrain from issuing it. But the better response is that the government can get an idea if it takes the trouble to do so.

Consider capital requirements. Regulators insist that banks raise a minimum percentage of their capital in the form of equity rather than debt. The economic rationale for this rule is that overleveraged banks are vulnerable to panics, which can lead to a financial crisis and recession. Meanwhile, capital requirements increase the cost of raising capital, which also hurts the economy. No one denies that capital regulations are necessary; the question is whether they should be 4 percent, 10 percent or perhaps 50 percent.

For many years, financial regulators adjusted capital requirements without providing any meaningful explanation. The introduction of cost-benefit analysis would force them to justify their decisions by comparing the cost with the benefit. The benefit -- the reduced risk of a financial crisis -- may seem impossible to calculate. But it’s not. Financial crises are recurrent events whose probability and average severity can be estimated.

The probability of a crisis depends on the amount of leverage in the system, which in turn is affected by capital rules. The cost to banks of issuing equity can also be estimated. In fact, all these estimates have been performed. While obviously rough, they provide a better basis for regulation than the alternative -- what academics call “expert judgment” but are more accurately termed “wild guesses.”

If a cost-benefit mandate had been in place before the financial crisis, banks would probably have been subject to higher capital requirements long ago, and that would have mitigated the crisis. Even conservative economists believe they were too low. Capital requirements are actually quite cheap. Other regulations, like the Volcker rule, an elaborate and probably fruitless effort to regulate banks’ involvement in securities markets, might well fail a cost-benefit analysis.

Cost-benefit analysis would make financial regulation cheaper and more effective; it would not end it.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Eric A. Posner at eposner@uchicago.edu

To contact the editor responsible for this story:
Paula Dwyer at pdwyer11@bloomberg.net