Thursday, September 13, 2012

The triumph of cost-benefit analysis in the regulatory process and the financial crisis

In a Bloomberg editorial, Cass Sunstein talks about how both Democrats and Republicans agree on the essential need for cost-benefit analysis in the regulatory process.

Professor Sunstein talks about the positive aspect of cost-benefit analysis in preventing hugely expensive regulations that have minimal benefits.

Then he opens the door into a critical weakness of cost-benefit analysis,
Some critics claimed that business had disproportionate influence over the process, exaggerating costs so as to block necessary safeguards.
This was in fact the case when the SEC originally tried to bring transparency to structured finance.

Wall Street and its lobbyists effectively argued that the benefits of investors having all of the useful, relevant information in an appropriate, timely manner did not outweigh the cost of providing this information.

As Interthinx's Ann Fulmer pointed out, the cost to the mortgage finance industry of this lack of information was $2 trillion.

As an expert in transparency for structured finance securities, I can assure you that the cost of providing all the useful, relevant information in an appropriate, timely manner is not $2 trillion dollars.
Others said that important protections had become vulnerable to “paralysis by analysis,” because the need to assemble information about costs and benefits, and to establish that benefits justify costs, can be difficult and time-consuming....
It is also true that regulators often face considerable uncertainty, and they have to give ranges for both costs and benefits, rather than specifying a single number. 
There are also continuing questions about scope, including the role of cost- benefit analysis in the context of .... financial regulation, where the benefits may be especially hard to quantify.
The one good thing to come from the latest financial crisis is that we can now do a cost-benefit analysis for financial transparency.  This cost-benefit analysis only applies to what your humble blogger refers to as valuation transparency and not price transparency.

Valuation transparency refers to ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can make a fully informed investment decision.  This covers ultra transparency for banks and observable event based reporting for structured finance securities.

Price transparency refers to making the last price at which a security was sold available and making multiple bids or offers that Wall Street is willing to transact at available.

The way the investment process works, the important form of transparency is valuation transparency.  Valuation transparency is important because it allows market participants to independently assess the risk and value a security.

It is only with the independent valuation of a security that an investor can tell if they want to buy or sell at the price being shown by Wall Street.

It is only with the independent valuation of a security that an investor can tell if the last buyer or seller was the bigger fool.

So what is the benefit of valuation transparency?  According to Ms. Fulmer, to the nation as a whole this benefit was $13 trillion.  This was the cost associated with the housing crisis.

So what is the cost of providing valuation transparency?  Less than $10 billion annually.  This figure reflects detailed conversations with individuals at the leading global information technology firms for what it would take to implement my firm's patented information technology to deliver valuation transparency.

Clearly, the benefits of providing valuation transparency are orders of magnitude greater than the cost of providing valuation transparency.

As a result, the SEC, CFTC and the bank regulators should be publishing regulations requiring disclosure of all the useful, relevant information in an appropriate, timely manner.

In doing this cost-benefit analysis for valuation transparency, my intent was to cover all current areas of finance and any that might be developed in the future.

Without a one-time cost-benefit analysis that covers all valuation transparency regulations, Wall Street will argue that each area of finance needs its own cost-benefit analysis.

The danger of doing a cost-benefit analysis on each area of finance is that Wall Street will show that the cost of valuation transparency exceeds the benefit at the time the regulation is passed.  Subsequently, the area of finance will grow so large that when it fails because of a lack of valuation transparency it brings down the entire financial system (see structured finance).

1 comment:

Anonymous said...

I wonder if Otto Eckstein would be appalled to see how lobbyists have hijacked his concept of cost-benefit analysis (CBA) as a means to substantially delay or even terminate meaningful regulatory reform.

An old saying around D.C. is that real power is the ability to prevent from happening that which should occur for the benefit of the public.

Ever since the EPA adopted CBA in 1969, it has spread to other agencies like wildfire. The lobbyists love it as it gives them a powerful tool to derail regulations meant to curtail the worst of industry practices.

As mentioned in the article, inflating the purported cost of a regulation (through the calculations provided by a friendly FRAC economist/group) often works by showing a massive burden to industry.

However, equally important is the inability to understand the potential for large-scale costs in the absence of the needed regulation. That was the situation faced by the SEC when it first proposed Reg AB and its disclosure provisions were watered down by MBA lobbyists.

As this financial crisis has shown, costs to the global economic system from large areas of opacity can be staggering, even when the area starts out fairly small.

The reason for this development should be clear to readers of this blog and the FCIC report on the crisis.

Because huge profits are available to the industry in areas of opacity, the area draws in massive amounts of money from which are derived even greater industry profits and bonus payouts.

What this means is that any CBA that is done while the area to be regulated is small will perforce fail to properly calculate the benefit of prevention years later when the area is many times the size it once was.

Thus, at least in the financial sector, any CBA involving opacity and the benefit of transparency is most likely doomed to overstate the cost to the industry and significantly understate the benefit of preventing a crisis.