On March 9, the Biden administration issued an executive order directing U.S. regulators to “assess the financial stability risks and regulatory gaps posed by the ongoing adoption of digital assets” and to recommend specific policy, regulatory and legislative actions within 180 days.
Thomas L. Hogan is senior research faculty at the American Institute for Economic Research (AIER). He was formerly chief economist for the U.S. Senate Committee on Banking, Housing, and Urban Affairs.
The heads of the U.S. regulatory agencies already claim to conduct careful analysis that weighs the costs and benefits of new rules before putting them into effect. Federal Reserve Chairman Jerome Powell, for example, described cost-benefit analysis as “a very fundamental part of what we do.”
Yet evidence from existing regulations contradicts such claims. It suggests that a careful approach to the regulation of cryptocurrency is highly unlikely.
Regulatory cost-benefits analysis
In a recent paper, I reviewed the proposed and final versions of 27 of the most important changes in bank capital and liquidity regulations from 1986 to 2018 in order to assess whether U.S. regulators evaluate the effects of new regulations thoroughly.
I found that in zero – yes, zero – of these cases did the regulators conduct a quantitative cost-benefit analysis to ensure that their regulations would not harm the banking system or the U.S. economy.
In five of the 27 cases, the regulatory proposals claim that the new rule would create net benefits for the economy. But if you read the proposals carefully, you find that is not so. In each case, they initially claim that the benefits are large, but they later admit that the magnitudes of the benefits are actually unknown.
In the 2003 implementation of the rules known as Basel II, for example, the rule proposal states that “the anticipated benefits well exceed the anticipated costs” (emphasis added). They later acknowledge, however, that the benefits of the rule cannot be measured since they are “more qualitative than quantitative.” If the benefits cannot be measured, how can we know that they “well exceed” the costs?
Similar language is used in other proposals. The 2011 market risk capital rules discuss only “qualitative benefits.” The 2013 liquidity coverage ratio (LCR) regulation describes the evidence as “qualitative in nature.” No quantitative evidence is ever provided.
The regulators claim that the benefits of their rules exceed the costs, but in reality, they have no idea how big the benefits are.
The costs of regulation
Uncertainty about the benefits of regulations might not matter if the regulations had no costs. But there are always costs. The costs of regulation might be borne by consumers, bank employees, corporate stakeholders, or even U.S. taxpayers.
New rules increase the complexity of the regulatory system, which – like a complex tax code – enables banks to avoid their regulatory burdens. Complex regulations are less effective at identifying bank risk. They can even push banks to take more risk than they normally would, such as regulations that encouraged banks to increase their holdings of mortgage-backed securities and collateralized debt obligations, which turned out to be a major cause of the 2008 financial crisis.
Regulations greatly increase banks’ operating and compliance costs. That disproportionately affects smaller banks that cannot afford teams of lawyers and compliance officers, and it creates barriers to entry that limit competition. Following the Dodd-Frank Act of 2010, for example, only one new bank was chartered from 2011 to 2016, compared with an average of 144 per year from 2000 to 2007.
While regulators are unclear about the benefits of regulations, they consistently underestimate the costs. None of the 27 rule proposals I reviewed considers the costs of greater inequality or how regulatory complexity might increase bank risk.
I found several instances in which the regulatory proposals misstated or misrepresented the research they cited. Sometimes they misinterpreted the findings of a paper or did not understand the difference between the study’s assumptions and its results.
In a few cases, the research cited by the regulators actually showed that their proposed rules would lead to net costs rather than net benefits. For example, the net stable funding ratio (NSFR) rule does not include cost-benefit analysis, but it does rely on a study from the Basel Committee on Banking Supervision (BCBS). The regulators claim that the BCBS study shows that the NSFR would benefit the U.S. economy.
But what the BCBS study actually says is that in its base-case scenario the NSFR creates a net benefit only when bank capital ratios are below 11%. When capital ratios are above 11%, the rule will reduce growth in the economy (and therefore in living standards).
At the time the NSFR was proposed in 2016, every bank subject to the rule had a capital ratio above 11%. Every single one! Thus, the BCBS study cited by the regulators themselves showed that the NSFR rule would be harmful to society.
This is the level of shoddy research you should expect in proposals to regulate the crypto industry.
Anyone predicting careful, well-researched crypto regulations needs to lower their expectations. It ain’t gonna happen. At least not if history is a useful guide.
Most financial regulators do not conduct cost-benefit analysis of new regulations. Regulators often claim that the benefits of a rule exceed the costs, even while admitting that the benefits are unknown. They ignore the unintended consequences of increasing inequality and financial risk. In some cases, the research cited in favor of their proposed rules actually shows that those rules will on net be harmful to society.
The cryptocurrency industry should look with skepticism on the promises of regulators and politicians. Their claims of careful, well-researched regulations are simply unfounded.
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