Cost Benefit Analysis and Financial Regulation

1. Cost Benefit Analysis and Financial Regulation Kevin Davis Commonwealth Bank Group Chair of Finance Director, Melbourne Centre for Financial Studies http://www.melbournecentre.com.au June 2006

2. Outline • Some Starting Principles and Consequences • Cost Benefit Analysis • Regulation Impact Statements • The Business Cost Calculator • Some Questions http://www.melbournecentre.com.au June 2006

3. Some Starting Principles • All regulatory change involves a cost benefit analysis • But • By whom? • How detailed, how accurate, implicit v explicit ? • For whom – social or private cost-benefit? • Who knows the results? • Is there learning from back-testing? http://www.melbournecentre.com.au June 2006

4. Some Starting Principles • Those responsible for regulatory change should be accountable • For rigorous, informed, analysis and decision making • Accountability requires transparency and disclosure • ex ante: Are changes justified, best possible? • ex post: What was cause of unexpected outcomes? http://www.melbournecentre.com.au June 2006

5. Some Starting Principles • Design of good regulation requires • Good information • Good analysis of consequences • Required information is dispersed and held by diverse stakeholders • Analytical ability/approach to assessment can differ between stakeholders http://www.melbournecentre.com.au June 2006

6. Some Starting Principles • Regulatory change is a battle of vested interests • Private interests of legislators and regulators • Private interests of private sector participants • Social interests as espoused by …….? http://www.melbournecentre.com.au June 2006

7. Some Consequences for the Regulatory Design Process • Public consultation is desirable to gain information, test analysis • But, public consultation may involve little more than spirited debate in pursuit of private interests dressed up as social interest • An explicit framework for assessing social costs and benefits and distributional (private) effects is warranted with results subject to public scrutiny • for good decision making • for accountability • Do we do it appropriately? What else can be done? http://www.melbournecentre.com.au June 2006

8. Cost-Benefit Analysis • The UK’s FSA has led in requiring explicit application of cost benefit analysis of expected effects to proposals for regulatory change • “CBA sorts those economic impacts into costs and benefits, and, where possible and worthwhile, quantifies them using statistical techniques and economic analysis”. http://www.melbournecentre.com.au June 2006

9. Cost-Benefit Analysis • Not a simple process • Some effects not quantifiable • Expected effects are “model dependent” • Linkages, interactions need to be understood to identify indirect effects • Discount rate for future costs and benefits? • Possible (virtual) irreversibility of some changes and need for “real options” approach • Doesn’t capture distributional effects but • Helps identify key consequences • Can (via sensitivity analysis) assess risks http://www.melbournecentre.com.au June 2006

10. Cost- Benefit Categories FSA handbook lists six cost-benefit categories • Direct costs (to regulatory agencies) • Compliance costs • Quantity (output) effects • Quality effects • Product variety • Efficiency of competition Note: price changes are not included • gains/losses to sellers/buyers net out • output consequences of price change matter • distributional effects may matter http://www.melbournecentre.com.au June 2006

11. Cost Benefit Approach • NERA review of FSA approach describe it as: • Suggest emphasis on six categories constraining, conducive to “tick-box” approach • Greater need for analysis/understanding of eventual effects, including interaction with existing regulatory framework http://www.melbournecentre.com.au June 2006

12. Cost-Benefit Analysis “a successful CBA might be rather like an impressionist painting – much less detailed than a photograph but much more recognisable than an abstract image would be”. http://www.melbournecentre.com.au June 2006

13. The Australian Approach • Consultation processes • Public v “quasi public” (with vested interests) • Regulation Impact Statements • Required by legislation • ASIC and APRA – typical format http://www.melbournecentre.com.au June 2006

14. Regulation Impact Statements • Rarely quantitative • Generally “low cost” • Guesstimate – one to two person weeks of work for analysis /drafting for RIS such as • APRA Prudential Accounting Treatment of Capitalised Expenses Recognised by Authorised Deposit-Taking Institutions (ADIs) (Dec 2003) • ASIC Proposed class order relief to simplify oral general advice warnings (Nov 2005) http://www.melbournecentre.com.au June 2006

15. The Business Cost Calculatorwww.industry.gov.au • Automated, standard process for policy development; • uses activity-based costing methodology; • first-round effects only, to indicate size of compliance burden; • not a costing of total impact of a regulation or policy • designed to generate information for use in policy processes • Regulation Impact Statement (RIS) • Small Business Impact Assessment (SBIA) • does not replace any RIS or SBIA requirements http://www.melbournecentre.com.au June 2006

16. Business Cost Calculator Steps • Define problem, possible reason for government involvement, objectives sought • Consultation, identification of existing relevant policy • Identify all regulatory options (including self regulation), effectiveness in meeting objectives, and number of businesses affected • Quickscan of relevance of business cost categories • Notification, education, permission, purchase cost, record keeping, enforcement, publication and documentation, procedural, other • Information gathering • Policy proposal, businesses affected, tasks performed by business • Estimate costs using activity based costing • For each cost category, activities such as announcing, establishing, compiling, consulting, filing, organising, purchasing • Internal cost (labour) and outsourced cost (purchase) • Once only and ongoing costs • Incorporate estimated compliance costs into cost benefit analysis http://www.melbournecentre.com.au June 2006

17. Business Cost Calculator Steps Problem and Objective Develop Options Quickscan Information Gathering Cost Options What is Next? Consultation http://www.melbournecentre.com.au June 2006

18. The Business Cost Calculatoraspects and issues • Useful as an organising and recording process • Only compliance costs estimated • Technical Issues • no discounting of future costs (acknowledged)! • Prescribes eitherinternal labour or outsourced purchase costs • Inadequate (eg if reporting requires purchase of new software and staff time) • Has industry used/assessed it? • Should estimates be required to be made public as part of R.I.S? http://www.melbournecentre.com.au June 2006

19. Questions • Is consultation process for regulatory change adequate for information gathering, informed decision making? • Should explicit cost-benefit analysis be required? • Funding the additional resource cost • Who should do it – regulators or independent consultants? • How is accountability for thorough analysis of regulatory change improved? http://www.melbournecentre.com.au June 2006