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Dean Furbush is Special Consultant for Economists Incorporated. His experience with federal rules comes from service as an economist at the Council of Economic Advisers, the SEC, and the CFTC, and as Chief Economist and then Executive Vice President Transactions Services for the Nasdaq Stock Market.
The Securities and Exchange Commission (SEC) has proclaimed a significant new role for economists in its rulemaking process. Former SEC Chairman Mary Schapiro described the role in testimony before Congress, and SEC economists and lawyers described it in a joint memorandum, “Current Guidance on Economic Analysis in SEC Rulemakings.” If the SEC truly integrates economic thinking into its rulemaking process and is willing to heed the qualitative and quantitative learning such involvement brings, U.S. financial markets, their participants, the capital formation process, and therefore the country, will see significant benefits.
The SEC’s commitment to the new role for economics is shown by its staffing of a 60-person Division of Risk, Strategy, and Financial Innovation (RSFI) mostly with Ph.D. economists. RSFI involvement in the rulemaking process received generally positive reviews in a June 2011 report of the SEC’s Office of Inspector General (OIG), a report done with assistance from a highly-respected financial economist, Professor Albert S. Kyle. According to this report, RSFI has been involved with several key rule filings. These include filings addressing credit risk, swap execution facilities, investment advisor reporting, municipal advisor reporting, conflict mineral regulation, and clearing agency standards.
The SEC’s recent push to increase the role of economists in the creation of rules governing U.S. securities markets stems from the SEC’s intent to understand its rulemaking options and the impact its decisions will have on the choices made by investors and traders. Some have incorrectly asserted that economists are primarily predictors of future prices and values. Certainly, economics can involve predictions, but economic analysis primarily involves understanding decisions and their consequences, both intended and unintended. That the SEC sees this point is shown by its setting forth four functions for economic analysis to fulfill in the rulemaking process:
1. Identify (a) the need for the rulemaking and (b) the mechanism for how the rule will meet that need, that is, the “theory of change.” Writing down these two elements has great practical value later in the analysis when alternative proposals are being considered.
2. Describe the baseline, the world in which the rule will operate. The SEC has identified the importance of “You Are Here” on the map. Those who don’t know their starting place are unlikely to get where they want to go. But unlike a spot on the map, this baseline is not static. Rulemakings require a dynamic baseline addressing how the current state would evolve without the rule – a “but-for world.” Moreover, the baseline has multiple dimensions: costs and benefits, efficiency, competition, and capital formation.
3. Identify and evaluate reasonable alternatives, including doing nothing, which amounts to playing out the dynamic baseline with no new regulation.
4. Evaluate likely impacts of the proposed rule and the reasonable alternatives considered – the benefits and the costs – from a qualitative and quantitative standpoint. For a rule to make sense, its social benefits must exceed its costs, and the excess of benefits over costs must be greater than for any alternatives, including doing nothing.
If economic analysis can fulfill these four functions, that would greatly improve the SEC’s rulemaking process. Strong economic analysis is definitely needed in the light of recent regulatory changes, especially including the Dodd-Frank Act regulations, and in the light of recent market discontinuities. Such discontinuities may arise from many factors ranging from technology advances and technology failures to natural disasters and terrorism. The last includes the growing potential for cyber-disruption in all its possible forms, including distributed denial of service (DDOS) attacks, designed to cripple markets. Economic analysis will help identify the costs and risks that participants in financial markets will or will not consider in their decision making and thus determine if regulations are needed to ensure appropriate risk management.
Clues as to the SEC’s efficacy in increasing its use of economic analysis can be gleaned by examining the SEC’s just-released (November 2, 2012) Final Rule regarding clearing agency standards (https://federalregister.gov/a/2012-26407). The voluminous release (627 footnotes) takes into account comments solicited in the Federal Register filing of March 16, 2011. Section V, entitled “Economic Analysis,” addresses the four stated functions. It concludes that the rule is in the interest of market participants, and particularly that it is efficiency enhancing, less burdensome than more prescriptive alternatives, and in harmony with other regulatory regimes in the United States and internationally.
While the steps taken to increase the use of economic analysis at the SEC are promising, it remains uncertain if they go far enough and whether economic analysis is truly integrated into the SEC’s thinking or is just an add-on. One problem is that economic analysis now is involved only in response to initiatives of other SEC departments and not in initiating recommendations. Today RSFI is not a rulemaking division of its own. It is only an advisory division supporting the rulemaking process, which continues to be run by lawyers in other divisions. Moreover, after rules have been established, economic analysis should be used to monitor and evaluate their effects. Given the complex and difficult financial environment and the high stakes involved in many SEC rulemakings, economic analysis should be involved in every step of the process from the consideration of potential new rules to the determination of the consequences of any rules that have been adopted.