By Jonathan B. Wight
There is a movement afoot to make all regulations affecting banks and financial markets subject to cost-benefit analysis. The purpose is ostensibly to make more sensible rules; the hidden agenda may simply be to gut reforms that arose out of the 2008 debacle.
I am sympathetic to the claim that bankers feel harassed by regulations. There are presumably much simpler rules (e.g., about leverage) that could substantially lower risk.
But asking all rules to abide by cost-benefit calculations is a fool’s errand. Much depends upon our imaginations of things unknowable—such as contagion effects and financial interconnectedness. As Tolstoy notes in War and Peace, “What theory or science is possible when the conditions and circumstances are unknown and the active forces cannot be ascertained?”
What is required in making rules is some degree of judgment or wisdom, based on experience and a heady dose of common sense. When Adam Smith proposed regulating financial markets by imposing an interest rate ceiling at 5 percent, he noted:
“In a country, such as Great Britain, where money is lent to government at three per cent and to private people upon a good security at four and four and a half, the present legal rate, five per cent, is perhaps as proper as any.” (WN pp. 356-357)
This is his judgment, based on history and common sense, and subject to change should circumstances require it. It is not a scientific determination of the correct regulations, which would require omniscience that is not in evidence in the human species.
A more formal analysis opposing the proposed cost-benefit law is found in The Yale Law Journal, by John C. Coates, IV, entitled “Cost-Benefit Analysis of Financial Regulation: Case Studies and Implications.” Here is the abstract:
“Some members of Congress, the D.C. Circuit, and the legal academy are promoting a particular, abstract form of cost-benefit analysis for financial regulation: judicially enforced quantification. How would CBA work in practice, if applied to specific, important, representative rules, and what is the alternative? Detailed case studies of six rules—(1) disclosure rules under Sarbanes-Oxley section 404; (2) the SEC’s mutual fund governance reforms; (3) Basel III’s heightened capital requirements for banks; (4) the Volcker Rule; (5) the SEC’s cross-border swap proposals; and (6) the FSA’s mortgage reforms—show that precise, reliable, quantified CBA remains unfeasible. Quantified CBA of such rules can be no more than “guesstimated,” as it entails (a) causal inferences that are unreliable under standard regulatory conditions; (b) the use of 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 laws. Expert judgment remains an inevitable part of what advocates label “gold-standard” quantified CBA, because finance is central to the economy, is social and political, and is non-stationary. Judicial review of quantified CBA can be expected to do more to camouflage discretionary choices than to discipline agencies or promote democracy.”