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Moderate Democrats helped Wall Street avoid regulation in the '90s. They're doing it again.

An apprehensive Sen. Warren.
An apprehensive Sen. Warren.
Astrid Riecken/Getty Images

Republicans on the campaign trail aren’t exactly shy about their desire to roll back President Obama’s bank regulations. Donald Trump has called Dodd-Frank a "terrible" "disaster," Ted Cruz has introduced legislation to abolish the Consumer Financial Protection Bureau (CFPB), and Marco Rubio has claimed, incorrectly, that more than 40 percent of small and midsize banks were wiped out by the financial reform law.

But the real threat to tough Wall Street regulation isn’t just on the campaign trail. It’s also in Congress, where a coalition of Republicans and a few moderate Democrats — like Sen. Mark Warner (D-VA), Sen. Heidi Heitkamp (D-ND), and Sen. Joe Manchin (D-WV) — are working on legislation that would severely curtail regulators’ power and make it easier for banks and other financial organizations to escape scrutiny, a move Elizabeth Warren and other liberal reformers are fighting.

The lawmakers want to subject financial regulation to what’s known as "cost-benefit analysis," a practice currently used to weigh health, safety, and environmental regulations. Applying it to financial rules too may sound reasonable, but it’s not — and, in fact, could severely undermine Dodd-Frank and the entire post-crisis effort to rein in Wall Street.

Regulating banks isn’t like regulating pollution


Obviously there’s nothing wrong with weighing the pros and cons of proposed rules. And when it’s relying on good evidence, and done carefully, cost-benefit analysis can be an important tool for, say, the Occupational Safety and Health Administration or the Environmental Protection Agency. Those groups are currently subject to oversight from the Office of Information and Regulatory Affairs (OIRA).

The proposed legislation would subject CFPB, the Commodity Futures Trading Commission, and other financial regulators to a similar process, requiring a strict quantification of benefits and costs of financial regulations, letting OIRA delay or veto rules that fail, and making it easier for judges to strike down regulations in court.

The problem is that financial regulations are just fundamentally different from, say, pollution regulations, or office safety rules, in at least three key ways:

  1. The financial system is "constructed" through economic rules in a way more "natural" systems of health and environment are not. Since the effects of financial regulations are determined by economic institutions and other financial regulations, it is virtually impossible to get reliable numbers by considering regulations by themselves.
  2. As opposed to more static, natural systems, financial systems are dynamic, evolving constantly to both market conditions and the rules themselves. Static cost-benefit analyses aren’t able to correctly compute or conceptualize these changes.
  3. Disagreements about the costs and benefits in natural systems can turn to the hard sciences to try to solve them. Disagreements about constructed systems must turn to economists, who use varying economic theories with intractable disagreements. Combined with the problems above, the results are no better than "guesstimates," which will cause weaker rule writing.

There’s also a case to be made for the limits of cost-benefit analysis in general, as it tends to undercount benefits even when used in realms for which it’s better suited. What’s more, empowering OIRA to directly intervene in financial regulations could overwhelm the tiny office. As Americans for Financial Reform notes, OIRA "has only 50 employees, as opposed to tens of thousands of employees at the various [financial] regulatory agencies" and "lacks substantive expertise in financial matters.

But even putting these matters aside, cost-benefit analysis is uniquely bad for financial regulation, and risks creating worse rules that put the financial system in greater danger.

Capital requirements can’t be analyzed the same way as lead rules

Lead pipes: they're bad for you
A sign announcing lead pipe replacement.

To understand why this is a bad idea, it’s helpful to work through an example. This is what Harvard law professor John Coates, a leading critic of extending cost-benefit analysis to financial regulations, does in a recent paper. His case studies show that cost-benefit analysis will result in "guesstimation" at best. As Coates told me, "Back in 2014, I asked proponents of cost-benefit analysis in financial regulation for a nontrivial rule that benefited from a quantified CBA that you could achieve consensus on. To this day, nobody has been able to give me one."

Consider one popular financial reform that should be easily quantifiable: increased capital requirements. Both Greg Ip of the Wall Street Journal and Eric Posner of University of Chicago Law School argue that capital requirements would be a perfect test case for cost-benefit analysis.

To do a cost-benefit analysis of capital requirements, we need to know the benefits of avoiding such a crisis, and the costs of the new rules imposing higher capital requirements. Unfortunately, estimates of the costs of a financial crisis range widely. Some estimates use Harvard economists Carmen Reinhart and Kenneth Rogoff’s work to estimate a price tag of between 1 percent and 20 percent of GDP in lost output. The Dallas Federal Reserve argued that the cost is between 35 percent and 80 percent of GDP. Other estimates argue that it could be well over 100 percent of GDP. Still others argue that the Federal Reserve could have avoided all negative effects of a financial crisis, so the cost is zero. These are four reasonable-enough arguments, yet there is no overlap between any of them, and the differences between them are tens of trillions of dollars.

High-level reviews haven’t helped. The BIS reviewed 21 studies and found that their estimates ranged from 16 percent to 302 percent of GDP. BIS took the median and mean of these studies, yet any kind of confidence interval would be a massive amount of money. Part of the problem is that economists have strong disagreements on both what counts as a financial crisis and whether there are permanent effects to a crisis rather than temporary ones.

There’s no conclusion there, and there’s also no conclusion on the costs of higher-capital requirements from reduced credit. Because whatever results you could find, and they do vary, there’s not even a single theory by which to measure them. One popular argument is that they are zero, because, according to one economic theory, changing the capital structure of a bank to have more equity and less debt doesn’t change the value of the firm.

But another economic theory argues that there is a "pecking order," where a lack of information between agents of the firm causes different costs for debt and equity. In that world, a reduction in credit could hurt consumers. The results vary, but how to interpret those results also varies.

Cost-benefit doesn’t work when the rules themselves are creating the business they’re regulating

Stock photo of the stock market
This market — you didn't build that!
(Spencer Platt / Getty Images)

Cost-benefit makes the most sense in "natural" systems, not "constructed" ones. This distinction comes from Columbia law professor Jeffrey Gordon and his paper "The Empty Call for Benefit-Cost Analysis in Financial Regulation." How toxic lead is doesn’t change in response to economic institutions. But finance is, according to Gordon, "constituted by rules and the adaptation to rules." Beyond that, changes "in an important rule will change the system of finance not just through direct, immediate effects but through the subsequent adaptations."

The cost of a financial crisis is very dependent on everything else the government does. It’s reasonable to say that if we had a gold standard, allowed banks to fail rapidly, and had a very small government without stabilizing transfers, like we did in the late 1920s, the financial crisis would have resulted in a Great Depression. But instead we have our current system, which resulted in the much less brutal, though still painful, Great Recession. Even then, there are significant disagreements among economists as to the long-term costs of a recession, disagreements that can’t be resolved simply by pointing to statistics and the natural sciences.

The effect of drinking lead on your body, however, doesn’t change with the background institutions of the market economy, be they feudalism, laissez-faire capitalism, or social democracy. It’s true that whether there is universal health care and income support for basic nutrition changes the damages of toxic chemicals for individuals. But this "baseline" problem just weakens the overall case for cost-benefit analysis, and this problem is an order of magnitude worse for constructed systems.

Worse, there’s a dynamic element to financial regulation. Any financial regulation depends on all the other ones, so the goals are much less straightforward than, say, reducing the level of a toxic chemical. If there’s a perfect process for letting banks fail without causing a crisis, the benefits of higher capital requirements are less than they would be otherwise.

And unlike toxic chemicals, financial markets evolve according to those rules. Imagine the cost-benefit analysis of declaring we will do permanent bailouts of the financial system. That would certainly reduce the cost of a financial crisis. Yet it would introduce tremendous moral hazard that is impossible to quantify, given that we haven’t even been able to quantify it for the 2008 bailouts.

Cost-benefit analysis means weaker financial regulation

Virginia Democratic Party Holds Pre-Election Rally
Sen. Mark Warner (D-VA), one of the senators interested in subjecting financial rules to cost-benefit analysis.
Drew Angerer/Getty Images

With these criticisms in mind, it’s easy to see why CBA would lead to weaker overall rules than other ways of justifying economic analysis. First, it would cause everyone to immediately exaggerate their measures. This happens all the time, of course, with those for and against regulations taking low and high costs. But as Coates shows, there’s an order of magnitude of difference here, and finding consensus would be impossible. It would lead to less clarity over the impact of the rules.

Rather than prioritizing efficient, clear-cut, quantifiable rules, this would instead politicize the process even further. Estimates would be generated based on different economic theories and spotty data, and as a result there would be such a wide range of costs and benefits that any conclusion would be no more than a guesstimate. Coates notes that these guesstimates are "not a true alternative to expert judgment — it is simply judgment in (numerical) disguise." It would also allow both the executive branch and the courts to pick and choose among them based on their political priors.

And it would slow the process of writing rules and increase the uncertainty surrounding them. As Coates told me, "You are giving the politicians and the courts more to fight about, which changes the potential for sudden and unpredictable outcomes. The regulatory environment could get more uncertain." Professor Gordon notes that "since the financial system is dynamic, always adjusting to the rules, this would make it much harder to update those rules to a changing environment."

It’s not surprising that people who defend cost-benefit requirements and OIRA as having brought their own benefits to the worlds of safety and environment want to extend that umbrella further to financial regulatory agencies. Sadly, it’s a much different world, and we need to find other, better, and more appropriate ways of keeping regulators accountable.