Rules We Can Really Live By

By Karen Petrou

  • Judging U.S. rulemaking by its benefits to the public good, not just by its impact on private wealth, is transformational and, with a new CBA methodology, also more than possible.
  • Equitable rules can be both effective and efficient.
  • Maximizing the public good is not synonymous with redistribution or reverse discrimination.

In 1993, President Bill Clinton issued Executive Order (EO) 12866, creating hurdles ahead of federal rules that are “economically significant.”  This was measured by a cost of $100 million or more.  On January 20, President Biden began a long-overdue rewrite, stipulating that federal rules are henceforth to be judged not just by their impact on private wealth, but also by what becomes of the public good.

 The EO thus instructs the Office of Management and Budget (OMB) to rewrite the overarching rulebook on rules also to capture adverse implications for equality, health, the environment, justice, human dignity, and several other public-good criteria.  Critics instantly warned that this public-good focus diverts attention from the cost of rules for the companies they govern, and so it will to at least some degree.  But focusing regulatory analysis also on the long-term cost to the public good increases equity.  Increased equity means greater economic growth, fewer financial crises, and renewed political stability.  That’s worth $100 million.

The Public-Good Methodology

It’s more than clear that a new lens for financial regulation is essential not just for equity, but also for efficiency and effectiveness.  Just last year, global regulators measured the social cost of post-crisis rules for the biggest banks by the compliance cost to the banks themselves.  They did take a look at whether there might have been another social cost – reduced credit availability – but discounted it because, where banks had stepped back, nonbanks stepped in.  The agencies readily acknowledged that unregulated lenders pose an array of new risks, but nonetheless absolved any of their rules of any social cost up to and including those borne of the financial crises caused in March of 2020 by nonbank fragility.

Although the need for public-good regulation is irrefutable, how to balance qualitative social and political objectives with the allocation of private wealth – for that is fundamentally the task of all government rules – is a complex undertaking.  Effective regulatory cost-benefit analysis with a keen eye not only on regulatory burden, but also on the public good requires:

  • Meaningful Cost Measurement:  an amazingly large number of sweeping financial rules measure their cost only in terms of the number of pages of required filings and how much the filers must be paid to fill them out.  Sweeping capital and liquidity rules that have redesigned U.S. finance with both inequality and instability impact were measured by totaling how much capital or liquidity covered banks had versus how much they would have to have, not how realigned requirements alter business models.  This can only be done qualitatively, but had it been done, regulators might well have captured effects such as the 2019 repo crisis, the transformation of banks into wealth-management machines, and the rise of unregulated nonbanks.  Each rule is also and always measured only on its own, not in the context of other rules or of monetary and tax policy – i.e., in the reality beyond the single rule that drives markets and thus the public good. 
  • Distributional Cost-Allocation Assessment:  Many CBAs look only at aggregate totals to reassure the regulator that nothing untoward will happen to macroeconomic growth.  This might even be true – for example, aggregate credit availability might well remain or even grow.  Still, loans could also become available and affordable only to wealthier households and large corporations with lenders under the new rule replaced by unregulated ones.  In the first instance, racial inequity grows worse; in the second, financial instability is sure to rise.  And, in all cases, macroeconomic risk increases despite seemingly-suitable credit availability because unequal societies grow more slowly.  Credit availability is fine – it’s just the public good that isn’t.
  • Meaningful Benefit Analysis:  Many rules are said to benefit the public good because they advance “innovation,” “financial stability,” “financial inclusion,” or any number of other wholly qualitative criteria then costed out by the thoroughly inapplicable quantitative methods briefly described above that have to do with filing or bank costs, not these worthy objectives.  Buttressed by this “cost” estimate, each of these lofty benefits is then cited as an over-arching rationale for what the regulator proposes.  But, is innovation per se a benefit if transaction speed increases risk, costs, or conflicts of interest?  Are all sectors of the financial system made more stable or just one?  Is financial inclusion really achieved if those in the digital divide’s abyss are excluded?  Are communities as a whole “developed” or just certain investors or borrowers?    
  • Distributional Benefit Analysis:  Even after determining that a well-defined regulatory benefit is gained at reasonable cost, public-good regulation requires further analysis.  Are the customers who genuinely benefit from innovation skewed in terms of race, gender, ethnicity, locale, and/or economic wherewithal?  Does a benefit – e.g., stability – come at the cost of higher interest or fees and, if so, who is most likely to bear them?  Can benefits be more equitably achieved if classes of borrowers or consumers are disaggregated and restrictions or relaxations are then revised to ensure fairness and ease of access?  Would an accompanying change in another rule enhance the equitable impact of the new action?   
  • Information Symmetry:  Exploited markets are not efficient markets.  All too often, regulators rely on disclosures to ensure consumer protection.  However, consumers have little chance of actually understanding the financial products they select because disclosures are missing or, when required by law, impenetrable.  Most voluntary and even regulatory consumer-finance agreements give all the advantage to the provider.  And, as we’ve noted, consumers take many protections for granted that no longer apply when a nonbank offers a bank-like product.  Mandatory disclosures on critical payment, deposit, and fee safeguards would protect vulnerable consumers and reward sound practitioners. 

Real Costs, Real Benefits, Real Soon

As this brief overview of the regulatory cloaks in which real regulatory costs and benefits are currently hidden makes clear, U.S. rulemaking is far from objective.  It has picked winners – mostly industry commenters – leaving a lot of losers behind not because their social-welfare needs are beyond the reach of financial rules, but instead because financial rules never give them a thought.

There is simply no downside to forcing regulators to think beyond their own objectives and those expressed in all the industry comment letters on which final standards are based; indeed, the upside is all too obvious.

For more, see my January 27, 2021 op-ed in the American Banker.

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