Rules, Standards, and Complexity in the Cost Benefit Analysis of Capital Regulation

The following comes to us from Prasad Krishnamurthy, Assistant Professor of Law, U.C. Berkeley Law School.

The prudential regulation of banks by the federal banking agencies has traditionally been grounded in discretionary standards.  Recent calls for cost-benefit analysis of agency regulations have arisen, in part, from a deep skepticism toward broad grants of discretionary authority.  Under current law, the federal banking agencies are not required to give an explicit, efficiency-based justification for proposed regulations.

In my article “Rules, Standards, and Complexity in the Cost Benefit Analysis of Capital Regulation,”  which is forthcoming in Journal of Legal Studies for their Symposium on Cost Benefit Analysis in Financial Regulation, I consider the extent to which cost-benefit analysis can inform two important issues in the capital regulation of banks: (i) the choice of a rule or standard and (ii) the level of complexity in that rule or standard.  I analyze two central episodes in the history of capital regulation: (i) the adoption of a minimum capital requirement in early 1980s; and (ii) the introduction of a risk-based capital requirement in 1989.  These cases allow us to consider the historical context in which regulators: (i) introduced a rule into what had been a standard-dominated framework; and (ii) introduced a degree of risk-based complexity into what had been a simple regulatory scheme.  They also allow us to consider how these decisions could have been subject to cost benefit analysis using information that was available at the time.

I suggest that cost benefit analysis could have played an important role in clarifying the original case for a minimum capital rule.  During this period, regulators were faced with disturbing trends in bank capital ratios and the expected costs of large bank failures.  The existing framework of regulatory supervision appeared unable to reliably measure the increased risks in the banking sector and to force banks to adjust their behavior in response to these risks.  A minimum capital requirement allowed regulators to place some limitations on the consequences of bank risk taking without understanding the precise nature of those risks.

This understanding of the minimum capital requirement can help inform contemporary capital regulation when cost benefit estimates exhibit large disagreement.  There is a wide range of estimates for the cost of a substantial increase in bank capital requirements.  I suggest that when considering capital requirements for systemically important financial institutions under the Dodd Frank Act’s enhanced prudential standards, regulators should place more weight on estimates that allow minimum capital rules to play a greater proportional role in regulating systemic risk.  This greater emphasis is appropriate because of the relative advantage of a minimum capital rule in managing such ill-defined risks.

Cost benefit analysis could also have played a role in clarifying the reasons why regulators decided to adopt a risk-weighted capital requirement.   Regulators suggested that such a move was necessary because banks strategically responded to the unweighted requirement by increasing their asset risk.  They did not, however, offer an account of how banks were likely to respond to a risk-weighted capital requirement.  As a result, there was little discussion of the possibility that introducing a risk-based requirement would lock regulation into a cycle of defining ever-more-precise regulatory risk weights.

I argue that recognizing the endogenous nature of this dynamic has important implications for contemporary capital regulation.  I suggest that when considering capital regulation under enhanced prudential standards, risk weighting should play a proportionally small role.  The effectiveness of risk weighting is premised on a regulator’s ability to calibrate capital requirements to risk and to produce ever-finer risk estimates in the course of its dynamic, strategic interaction with banks.  This contrasts markedly with the premise of regulatory ignorance that motivates a minimum capital rule.

I conclude that requiring cost benefit analysis of capital regulation—or more generally, prudential banking regulation—is unlikely to resolve the major policy disputes in this area.  It may, however, improve the quality of regulatory deliberation and the representation of this deliberation to the interested public.  In the case of capital regulation, I suggest that such an analysis of the use of rules, standards, and complexity can inform current debates over enhanced prudential oversight under the Dodd Frank Act.  There is a substantial amount of quantitative uncertainty concerning the costs of imposing substantially higher capital requirements on systemically important institutions.  The analysis in this article suggests that, where possible, this uncertainty should be resolved in ways that place greater emphasis on relatively simple rules in maintaining systemic stability.

The full paper is available here.