REGULATION AND THE ENDOGENOUS PROVISION OF CONFIDENCE : THEORY AND ANALOGIES TO LICENSING , SAFETY AND FINANCIAL REGULATION

Recent years have witnessed renewed political and scholarly interest in consumer protection regulation; in the financial sector, most notably, legal scholars have proposed that safety regulation should govern financial markets (Warren 2007, 2008). In this paper, we ask whether the effects of safety regulation go beyond safety and might affect consumers' beliefs about the distribution of products they can use. We model “approval regulation,” where a government regulator must approve the market entry of a product based upon observable, unbiased and non-anticipable experiments. We show that even if regulator and firm disagree only about quality standards, the disagreement induces the firm to provide more information about its product than it would in the absence of regulation. Put differently, purely first-order disagreements in regulation will generate second-order consequences (more certainty about product quality). These second-order consequences of regulation are sufficient to generate firstorder effects among end-users (more consumption of superior products), even when users are risk-neutral. In other words, even if approval regulation produces little or no improvement in safety or quality, it still aggregates information useful to `downstream' product users; these users will exhibit higher consumption and will more readily switch to superior products. In contrast with libertarian analyses of entry regulation and licensure, the model predicts that entry restrictions may be associated with greater product or service utilization (consumption) (Law 2003; Law and Marks 2009), as well as greater price sensitivity among consumers. Because contemporary cost-benefit analyses ignore these second-order effects, they are unlikely to capture the possible confidence effects of approval regulation. Jerusalem Papers in Regulation & Governance 3 © Carpenter, Grimmer & Lomazoff W o rk in g P a p e r N o . 3 7 | S e p te m b e r 2 0 1 1 Acknowledgements: Earlier versions of this paper were presented at the Tobin Project Conference on Economic Regulation, White Oak, April 2009, and the Behavioral Economics and Financial Regulation meetings at Penn Law School, October 2009; we thank Charles Brown, Bruce Carruthers, Danny Goroff, Rick Hall, Richard Herring, Howell Jackson, Adam Levitin, Brigitte Madrian, David Moss, Annelise Riles, Charles Shipan, Susan Wachter and David Zaring for comments and criticisms on previous versions. We acknowledge the Tobin Project and the Alfred Sloan Foundation (2010-5-14 ECON) for generous research support. Comments, criticisms and corrections are most welcome. This paper functions in part as a technical appendix and extension to the published version of Carpenter, Grimmer and Lomazoff (2010). Jerusalem Papers in Regulation & Governance 4 © Carpenter, Grimmer & Lomazoff W o rk in g P a p e r N o . 3 7 | S e p te m b e r 2 0 1 1 Approval Regulation and the Endogenous Provision of Confidence: Theory and Analogies to Licensing, Safety and Financial Regulation Why not create a Financial Products Safety Commission charged with responsibility to establish guidelines for disclosure, collect and report data about the uses of different financial products, review new products for safety, and require modification of dangerous products before they can be marketed to the public? The agency could review mortgages, credit cards, car loans, and so on. It could also exercise jurisdiction over life insurance and annuity contracts. In effect, the FPSC would evaluate these products to eliminate the hidden tricks that make some of them far more dangerous than others and ensure that non pose unacceptable risks to consumers. An FPSC would promote the benefits of free markets by ensuring that consumers can enter financial services markets confident that the products they purchase meet minimum safety standards. Elizabeth Warren, Product Safety Regulation as a Model for Financial Services Regulation A financial products safety commission could help fill in the gap, particularly in relationship to products being produced by and invested in by regulated entities. Each product would have to have a stated objective (e.g. in what ways was it helping manage and mitigate risk; what was the risk profile for whom the product was intended). Its risk characteristics would be identified, using conservative models which paid due attention to the failures previously noted. The Financial Products Safety Commission would evaluate whether products provided significant risk mitigation benefits of the kind purported by the product. There would be a presumption that there “is no free lunch,” i.e., that higher returns could only be obtained at the expense of greater risk; and a strong assumption against complex products, the full import of which are hard to analyze. Joseph Stiglitz, The Financial Crisis of 2007/2008 and its Macroeconomic Consequences