1 June 2006 Cost Benefit Analysis and Financial Regulation Kevin Davis Commonwealth Bank Group Chair of Finance Director, Melbourne Centre for Financial Studies

2 June 2006 Outline Some Starting Principles and Consequences Cost Benefit Analysis Regulation Impact Statements The Business Cost Calculator Some Questions

3 June 2006 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?

4 June 2006 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?

5 June 2006 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

6 June 2006 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 …….?

7 June 2006 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?

8 June 2006 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”.

9 June 2006 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

10 June 2006 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

11 June 2006 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

12 June 2006 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”.

13 June 2006 The Australian Approach Consultation processes –Public v “quasi public” (with vested interests) Regulation Impact Statements –Required by legislation –ASIC and APRA – typical format

14 June 2006 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)

15 June 2006 The Business Cost Calculator 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

16 June 2006 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

17 June 2006 Business Cost Calculator Steps Problem and Objective Develop Options Quickscan Information Gathering Cost Options What is Next? Consultation

18 June 2006 The Business Cost Calculator aspects and issues Useful as an organising and recording process Only compliance costs estimated Technical Issues –no discounting of future costs (acknowledged)! –Prescribes either internal 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?

19 June 2006 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?