Matt Chase
The US Congress witnessed an increasingly rare moment of bipartisanship last May, when 33 Democratic members of the House of Representatives and 17 Democratic senators crossed the aisle to support rolling back Dodd-Frank Act regulations on small- and medium-sized banks. The vote was one sign that the United States is in a new era of deregulation, nine years after the passage of Dodd-Frank, which was tailored to fit a country reeling from the 2008–09 financial crisis, for which the blame was laid mostly at the feet of the banking industry.
Political gridlock in Washington may slow the deregulation process, but the momentum is already established. Since Donald Trump became president in 2017, the Environmental Protection Agency has loosened standards for the coal industry and weakened Obama-era vehicle fuel-economy rules. The administration has eased restrictions in health and education. New Supreme Court Justice Brett Kavanaugh is on record opposing the Consumer Financial Protection Bureau, an agency the president and many other Republicans have railed against.
“After the crisis, the sentiment in the country was definitely more proregulation,” says Chicago Booth’s Christian Leuz. “Trump saying ‘We’re going to roll back Dodd-Frank, or parts of it’ and the debate over the Consumer Protection Bureau have shown that we’re now going in the other direction. So the question has shifted. Now we are asking, ‘Did we overreach? Is there too much regulation?’”
This back-and-forth between regulation and deregulation is a hallmark of US financial history. Financial collapses and scandals often usher in demands for new regulation. The 1933 Glass-Steagall provisions, which separated commercial and investment banking, followed the 1929 Wall Street Crash. The 2002 Sarbanes-Oxley Act was a reaction to the Enron and WorldCom scandals. Dodd-Frank was enacted in 2010, following the 2008 financial meltdown.
But while the regulatory pendulum swings again, researchers are arguing in favor of a new paradigm. While some famous economists have long pushed for the kind of deregulation now being implemented, other researchers are finding that regulation can in some cases bring significant benefits, such as improved market competition. Their work is creating a new understanding of the thorny issue.
Deregulation was pioneered by the Chicago School of economists, including the late University of Chicago economists George J. Stigler, Milton Friedman, and Gary S. Becker. Now research is recognizing and describing complexity and subtlety in the relationship between regulation and outcomes.
For example, more stringent securities regulation can increase households’ willingness to invest in equity markets, according to Chicago Booth’s Hans B. Christensen and Mark G. Maffett and Booth PhD candidate Lauren Vollon. Analyzing data from the 31 member states of the European Economic Area from 2000 to 2013, the researchers find that two separate directives aimed at both cracking down on insider trading and market manipulation and enhancing consumer protections in the financial-services industry prompted households to increase their average equity ownership by 12 percent for one directive and 5 percent for the other. (See “Want households to invest more in stocks? Strengthen regulation.”)
Over-the-counter (OTC) stocks can attract more liquidity if their issuing companies are mandated to file disclosures with regulators, publish information in a recognized securities manual, are headquartered in states with stricter merit reviews, and are in higher-level Pink Sheets information tiers, find Humboldt University’s Ulf Brüggemann, University of Alberta’s Aditya Kaul, Chicago Booth’s Christian Leuz, and Ohio State’s Ingrid M. Werner. (See “On OTC markets, lowering the bar for regulation lowers market quality.”)
Making private companies report their full financial statements can create more competitive markets, according to an analysis of EU countries by Columbia’s Matthias Breuer, a graduate of Chicago Booth’s PhD Program. The requirement drove more companies to open (and to close), reduced market concentration, and lowered barriers to going public, Breuer finds, although he also notes that it did not make markets more efficient in terms of resource allocation. (See “The benefits, and limits, of financial-reporting regulation.”)
Dodd-Frank itself helps to improve worker safety, according to research by Christensen, Maffett, University of California at San Diego’s Eric Floyd, and Booth PhD candidate Lisa Yao Liu. The law requires all mine-owning public companies to report mining-related injuries and safety citations on their annual SEC 10-K and quarterly 10-Q disclosure forms, and to issue 8-K filings when they receive “imminent danger orders,” following serious safety breaches. These additional reports led to an approximately 11 percent decrease in mine-safety citations and a 13 percent drop in mining injuries in the roughly three years after Dodd-Frank went into effect, the researchers find. (See “Is Dodd-Frank an instrument of social change?”)
This evidence is helping to shape a new debate, which centers on how to make regulation better rather than eliminating it entirely. “People’s views have become a lot more nuanced. We have come to realize that there are limits to markets’ ability to find solutions to first-order incentive or information problems. The potential market solutions to these problems again suffer from information and incentive problems, making market solutions imperfect too,” says Leuz.
Stanford’s John H. Cochrane, who is also a distinguished senior fellow at Chicago Booth, believes there should be significantly less regulation but also says it has its place, as long as it’s well crafted and delivers the intended results.
“We’re in a moment of regulatory reform—there’s no denying that—both from the administration and from Congress,” Cochrane says. “The fact is, we just need better regulation, which includes the process by which regulation is made, rather than just more or fewer rules.”
This represents a significant change, as the Chicago School’s influence has prevailed for decades. In the run-up to the 1960s, the conventional wisdom among scholars and policy makers was that if there was a problem in a market, government regulation could fix it. Economists assumed, as everyone else did, that the solutions put in place through new laws had their desired effect.
“Good intentions were all that really mattered. There was a problem, you regulated it, and you just assumed that the problem would be taken care of,” says Chicago Booth’s Sam Peltzman. “Most of the world outside of economists still sees things that way, and we’ve gone through a bout of the folks in power seeing things that way.”
The unintended consequences of regulation often emerge when people being regulated have to consider their own professional survival and change their habits accordingly, says Chicago Booth’s Canice Prendergast. And policy makers can overlook the effects of rule changes on people who have to live by those rules, he says.
Consider attempts to regulate the behavior of teachers, says Prendergast. In the United States, the 2001 No Child Left Behind Act required a certain percentage of students to reach particular reading standards. The result was that teachers, evaluated on the basis of test scores, tended to focus much of their energy on students who were close to meeting, but did not quite meet, the standards, leaving the highest- and lowest-achieving students to fend for themselves, according to Prendergast’s research. (No Child Left Behind was effectively repealed in 2015.)
“In some instances, teachers actually tried to persuade the academically poor children to drop out of school, not exactly the objective you are looking for,” observes Prendergast. “That might get the teachers to the levels they need to keep their jobs, but certainly isn’t doing a significant portion of the class any services, especially those who need extra attention.”
Police reform—or just the call for it—highlights how people facing potential regulation also change their behavior. Prendergast notes that in recent years, police shootings of individuals have often led to a public outcry. In the wake of them, police are often highly aware that their behavior will be scrutinized more closely, and that they could be reprimanded or even charged criminally for making the wrong decision in the line of duty.
After a publicized shooting, “there is evidence that police officers can simply withdraw. They don’t engage, either because they’re worried they will be reprimanded if someone files a complaint, or because there is much more paperwork involved,” Prendergast says.
To him, the cases of teachers and police officers indicate that tightening up rules, or even threatening to do so, can potentially lead to new problems.
Canice Prendergast, “What Have We Learnt about Pay for Performance?” Economic and Social Review, Summer 2011
But in 1962, Stigler threw a wrench into this traditional way of thinking. In a groundbreaking paper on electricity prices, where the sellers were monopolies, he demonstrated that government regulation hadn’t lowered electricity prices as much as expected. If regulation didn’t work to bring prices toward marginal costs in a monopoly, what kind of effect was it having in other situations? Were government regulations at all effective in correcting private-market failures?
Stigler went on to introduce regulatory capture in a subsequent paper. (See “How George Stigler changed the analysis of regulation,” Winter 2015.) The theory, which earned him a Nobel Prize in Economic Sciences, suggests that regulators are captured and dominated by large, moneyed interests that can formally sway regulators to their favor. It prompted economists to approach regulation as they do other economic questions, dissecting regulations with models and empirical analysis, looking for actual effects and often not finding them to be as expected or promised.
This set off calls for deregulation, to allow the markets to sort out problems themselves. If regulation wasn’t having the intended effect, the argument went, it was not only unjustified, but it would cement the market power of dominant players, prevent new entrants, and thus stifle competition. Stigler’s colleague Friedman argued that government should shrink as much as possible to let competitive markets solve problems without interference. And Becker proposed extending free markets into areas such as organ donation.
Stigler’s capture theory takes into account the idea of rational ignorance—a person or a group of people don’t acquire enough knowledge about a topic because doing so would cost more than the benefit that the knowledge might offer. This means regular voters don’t know enough about banking regulations, for example, to really push politicians or regulators in one direction, leaving more wealthy and highly organized companies and political action committees to wield the real influence.
“It doesn’t matter very much to us. It matters a little, but not enough for us to spend the time and resources to really get adequately informed about the issue,” Peltzman says. “But you can be sure the regulated firms’ executives and lawyers, their workers’ representatives, and the regulators themselves know a lot, because they have a lot at stake.”
In 1976, Peltzman expanded on and formalized Stigler’s theory, suggesting that regulators bowed not only to the desires of industry. Peltzman argues that a regulator will lean toward a decision that optimizes political support from groups that have an interest in a regulation. However, when a crisis occurs, the public outcry is sometimes so large that politicians feel the need to do something—anything—in response. The result is often a large, broad push toward stringent regulations, followed by an eventual swing back to moderation.
The accounting and auditing profession provides an example of this theory. For decades, auditing firms policed themselves through peer review, and there were concerns audit firms were failing to thoroughly review each other’s work. After the collapse of Enron and WorldCom, Congress, as part of Sarbanes-Oxley, created the Public Company Accounting Oversight Board (PCAOB) to address the scandals.
Almost immediately after its implementation, credibility in companies’ financial statements increased. To illustrate, Stanford’s Brandon Gipper, Leuz, and Maffett demonstrate that investors responded more strongly to earnings news after auditors became subject to public oversight. This might seem like an obvious improvement to a casual observer. But it isn’t clear that a government takeover of auditing oversight was the only or best way to solve the problem.
“Could we have achieved improvements in peer review instead of through a quasi-government bureaucracy?” asks Leuz, who is an advisor to the PCAOB’s Center for Economic Analysis. “Had we given the peer-review scheme more bite and access to more significant ‘sticks’ or penalties—as the new PCAOB has—would we have gotten improvements? Quite possibly. The academic evidence does not say that regulation or oversight is always better.”
The cycle is one that Peltzman predicted. He argued that regulators would create rules and enforce them more strictly when a particular industry was doing well, but could be convinced to ease up when times were tough. Regulation and deregulation are a natural part of the political process and a way to balance the needs of industry and society, he says.
Only some companies were affected when a US law required mine owners to report information such as safety citations in their financial reports. However, mine-safety data from many more companies were publicly available by other means, providing researchers with both a test group and a control group to help them study the regulation’s effects.
“There’s going to be an ebb and a flow, and it’s going to be of a type that I argued [in 1976] is intrinsic to politics,” Peltzman says. “Sometimes you’re pro-industry and sometimes anti-industry. Regulators tend to be pro-industry when things are rough for industry, and anti-industry when things are going too well. You try to balance across all of the organized interest groups. I think it became, over time, a broadly accepted view.”
While the ebb and flow is likely to continue, there are signs of willingness on both sides of the political spectrum not just to rethink current or future regulations, but to reconsider the process of how those regulations are crafted.
During his tenure as president, Obama backed cost-benefit analyses in his attempt to revamp the Office of Information and Regulatory Affairs. Former House Speaker Paul Ryan (Republican of Wisconsin) put forth his Better Way plan, a conservative agenda developed after the 2016 election, which called for “a smart approach that cuts down on needless regulations while making the rules we do need more efficient and effective.”
Indeed, smarter regulation could produce better results, for example by fostering healthy competition. Peltzman says the complexity of laws and the rules that come out of them can create more confusion and unintended consequences. Dodd-Frank’s rules are so complicated that some banks have built multimillion-dollar compliance departments with the lawyers and accountants needed to stay in business. The result is that the law has fortified power in the hands of the current players, says Peltzman.
“Who can get into the business now?” he asks. “The incumbency advantage has just spread. The best of intentions are going to make the situation worse in the long run. They create new interest groups that have coalesced around the time-honored institution of keeping the outsiders out and crafting the rules to benefit whoever makes the rules. And it has nothing to do with the basic problem of financial instability.”
Chicago Booth’s Luigi Zingales suggests looking at regulation through a different lens, however. The standard thinking espoused by capture theory is that regulation tends to hurt competition, as moneyed interests ensure that laws consolidate their hold on a market. But Zingales says that recent changes to banking and telecommunication laws could in some instances spur competition.
Mobile-number portability has allowed customers to keep their mobile phone numbers when moving between carriers. Prior to MNP, changing mobile carriers meant reaching out to potentially hundreds of friends and associates, and changing business cards and websites, to reflect a new phone number. The hassle of changing numbers meant that mobile carriers could assume customers would stick around, even in the face of rising prices. MNP removed those roadblocks, allowing new players to enter the market.
“We’ve recognized that these things are a lot more complicated and that it isn’t as simple as ‘markets are good’ or ‘regulation is bad,’ or the other way around.”
Research by Daegon Cho of Korea Advanced Institute of Science and Technology and Carnegie Mellon’s Pedro Ferreira and Rahul Telang finds that MNP decreased market prices across 15 EU countries by 5 percent and increased consumer welfare by more than €3 billion per year between 1999 and 2006.
Banks have also long protected customer data, not only to keep accounts secure but to have an advantage when it comes to offering loans and other bank products and services. The EU’s PSD2 law in 2015 and open-banking rules that took effect in the United Kingdom at the beginning of 2018 make those data largely available to third parties. This opens up competition and, in theory, will save those customers money.
“Procompetitive regulation seems like an oxymoron sometimes, but it’s not,” Zingales says. “We always think about regulation as a way to reduce competition in the market or as a way to address a failure in the marketplace. Sometimes rules might be useful to actually facilitate competition in the marketplace.”
Leuz suggests that transparency regulation could be an example of such procompetitive regulation. It is different from traditional regulation, he says, because it essentially uses a price mechanism. In an overview of regulation research, he recognizes that some findings suggest disclosure mandates don’t always work as intended, and yet the idea of using transparency rather than other types of mandates can produce positive results. After all, Breuer finds that making private companies report full financial statements encouraged competition. And Christensen, Maffett, Floyd, and Liu’s research on Dodd-Frank’s effect on mine safety suggests that increasing transparency, rather than using command-and-control regulations, can make for smarter regulation. “[I]nclusion of information on social responsibility in financial reports can have real effects—even if this information is already publicly available,” the researchers write.
But a key question, adds Breuer, is what kind of regulation grows the economic pie. “I think we have clear evidence that regulations can reallocate the costs and benefits,” he says. “Way less is known about whether and which regulations really affect the size of the economic pie, especially if we’re talking about information regulations.” A growing economy would make everyone better off, whereas reallocating market share produces winners and losers. More liquid, competitive markets are good—but good for everyone?
Cochrane points to several failures of the current regulatory structure in the US. Chief among them is that rules aren’t well-defined, leaving companies at the mercy of regulators who may have axes to grind. In a 2015 blog post, Cochrane points to Dodd-Frank’s repeated references to “systemic” failures, although the legislation never clearly defines the term. Moreover, even a single provision, the Volcker Rule (which bans proprietary trading funded by insured deposits), is around 1,000 pages long, and so complex as to be nearly impossible to understand fully and comply with.
“The result is immense discretion, both by accident and by design. There is no way one can just read the regulations and know which activities are allowed,” Cochrane observes. “Each big bank now has dozens to hundreds of regulators permanently embedded at that bank. The regulators must give their OK on every major decision of the banks.”
Consideration for the effects such rules have on markets often gets lost in the vague and abundant language of legislation.
This is difficult to avoid. The problem with building better regulations is that there is no easy way to test their efficacy. “There are clear examples where regulation is needed, and the question is: ‘To what extent is the regulation that emerges from the political process the regulation we would like from an empirical view?’” asks Zingales.
It can be tricky for researchers to study the effects of regulations, particularly when they have to disentangle them from those of a crisis that inspired new rules. But Leuz has some ideas for how to proceed. For starters, he argues that some questions about regulations can be addressed by emulating the model used in medicine: randomized clinical trials allow drugs or procedures to be used on some patients to truly understand their efficacy. Implementing regulations more often in such or in similar ways would allow economists to see whether or not rules work and decide how to modify them to achieve desired results.
While it might not have been Congress’s intention, the mine-safety findings illustrate how such a system could work. In the case of mining, the data were publicly available, but the new rule required only some mines to include them in SEC financial-disclosure reports. That essentially produced the equivalent of a clinical trial, where some mines were subject to a new treatment and others were not. The mines required to report the data had fewer accidents and citations, likely because their investors, when safety issues were made salient, didn’t want to be on the hook for fines and payouts.
Information is also crucial. Companies have more data than ever about their customers and business. At the moment, economists don’t have access to much of these data. But Leuz argues that opening up those troves, even in limited or confidential ways, could significantly improve evidence-based regulation research.
“The biggest challenge for causal evidence and better policy-relevant estimates, however, is lack of relevant data that are sufficiently granular to identify and measure regulatory effects,” Leuz argues. “If we are serious about evidence-based policy making for financial regulation or accounting, regulators and standard setters need to actively help with generating relevant data and fostering research, essentially building economic analysis into the process of rulemaking.”
He adds that meta-analyses, which pool studies to make statistical conclusions, and a clearinghouse that summarizes the best research on topics related to regulation can help inform the decisions that have to be made by policy makers who need unbiased information.
For Leuz, evidence-based policy making holds the promise of transcending the old ideologies surrounding regulation.
“We’ve recognized that these things are a lot more complicated and that it isn’t as simple as ‘markets are good’ or ‘regulation is bad,’ or the other way around,” Leuz says. “These views still exist, but we should move beyond them and make room for theoretical and empirical research that helps us improve regulations, so that the new rules are based on or at least guided by evidence.”
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