Keynote Address at the Investment Company Institute 2014 Mutual Funds and Investment Management Conference

Encouraging Economic Discourse

Thank you for inviting me here today to deliver the keynote address at this important conference.  I am particularly pleased to be sharing this honor with Norm Champ, the Director of the Division of Investment Management.  As I will touch on today, my Division’s work with him and his staff exemplifies the type of detailed and in-depth economic thinking that I believe currently is – and should continue to be – a hallmark of the SEC’s approach to rulemaking.  Before I go further, however, let me remind you that the remarks I make today are my own and do not necessarily reflect the views of the Commission, Commissioners, or of SEC staff.[1]

The Impact of the Guidance

Two years ago this month – in a memorandum dated March 16, 2012 to be exact – my Division and the Office of the General Counsel laid out what we believed to be best practices in performing economic analysis in support of Commission rulemaking.  That memorandum, now publicly available and entitled Current Guidance on Economic Analysis in SEC Rulemaking – known as “the Guidance” for short – was, on paper at least, limited in its scope.  At its base, the Guidance does just two things.  First, it lays out the basic principles underlying a robust and transparent economic analysis in support of rulemaking.  Second, it states the fundamental precept that economists are part of the rulemaking process from the very start, and thus involved in those crucial policy discussions that occur before words are ever committed to paper. 

You can see how in one version of the world the Guidance could have remained a document with a limited purpose, one that provided useful tips on structuring an economic analysis within a rule release and got DERA economists invited to more meetings.  But the Guidance of this world is much more than that.  Let me be clear:  The Commission has always considered the economic effects of its rules and policy choices.   But over the past three years that I have been Chief Economist and the last two that I have overseen my Division’s work with the Guidance, I have come to believe that this seemingly simple document has focused and enhanced how the Commission and its staff approach economic thought and utilize the expert staff of DERA.  Today I’d like to talk about the Guidance a bit, and also consider what it might mean for the public’s engagement with the Commission. 

So stepping back for a moment, in case not all of you have committed the Guidance to memory, let me take a few moments to review what the document actually says.  The document emerged from a particular moment in time, when the Commission was reviewing its approach to economic analysis in rulemaking, and Congress and other constituencies were asking questions about the integration of economics into the rulemaking process.  During this time, with the passage of the Dodd-Frank Act, the Commission was responsible for promulgating a large number of rules covering a vast array of topics.  So after months and months of work, my staff and staff in the Office of the General Counsel circulated the Guidance within the Commission. 

Clocking in at 17 pages, the Guidance explains the four basic elements of a robust economic analysis.  First, identify the need for the regulatory action.  Second, articulate the “baseline” against which any potential economic effects can be measured.  (In other words, describe what the world looks like today, in the absence of the regulatory action.)  Third, explain alternative approaches to reaching the regulatory goal.  And fourth, lay out the economic impacts, including the costs and benefits, of the regulatory action and its principal regulatory alternatives.  The Guidance concludes with a discussion of the integration of economic analysis into the rulemaking process.  To quote the Guidance, “[DERA] economists should be fully integrated members of the rulewriting team, and contribute to all elements of the rulewriting process.” 

And that’s the recipe for an SEC economic analysis.  Sensible and straight-forward.  But just like with many recipes, there is a secret to the success of the Guidance.  A secret ingredient that isn’t listed.  As you may have heard, my time at the Commission is drawing to a close and with that comes certain freedoms.  And so I’m going to give away that secret. 

The truth is that the Guidance would never have been successful without the incredible staff at the Commission. 

Of course, I must acknowledge the unwavering support for these efforts that was given by former Chairmen Schapiro and Walter, as well as by Chair White.  Each of the Commissioners also has been crucial in ensuring that our rule releases have complete and even-handed economic analyses.  And senior staff from all Divisions are due credit for consistently emphasizing the importance of the Guidance. 

But the people who deserve most of the credit are the staff attorneys and staff economists who do the vast majority of the work to actually implement the Guidance.  These were the individuals who, cloistered in windowless conference rooms, hammered out the narratives that added up into the high-quality economic analyses that the public eventually sees.  I would be remiss if I did not take this opportunity to publicly express my heartfelt admiration for all of those who were and continue to be part of the success of the Guidance.  

As a result of all that hard work, I believe our rules are strong, robustly supported, and transparently demonstrate the unparalleled expertise of the Commission and its staff. 

But now recall what I said about the scope of the Guidance.  The Guidance by its terms only applies to the development and drafting of rule releases.  While certainly central, rule drafting is only one part of what the Commission does every day.  Indeed, there are many other policy initiatives that are bubbling away on the proverbial stove.  So if the Guidance has this seemingly limited scope, why did I talk in the beginning about its importance to the agency?  To answer that question I need to speak as an economist in the language of economists.  In economic theory, there exists the concept of “spillover effects.”  Wikipedia tells us that these effects are “externalities of economic activity or processes that affect those who are not directly involved.”  In layman’s terms, it’s a secondary effect. 

Well, the Guidance has had a rather significant spillover effect.  As DERA became larger and the Guidance became integrated into the rulewriting process, it became natural for DERA to similarly be included in the dozens upon dozens of other initiatives that didn’t directly involve drafting a rule.  We started proposing projects in a variety of spaces and found receptive audiences across the Commission.  To run through the myriad ways that DERA contributes to the mission of the Commission would take all of my time and probably the rest of the day and night, and if I had a captive audience I would be more than happy to regale you with myriad examples.  But in an effort to stay within my allotted time, I’ll refrain.  But I do not think that it is an overstatement to say that ‘economics’ is a common language that we speak at the Commission.  I’ve heard attorneys comfortably and correctly deploy technical terms such as “externalities,” “economic rents,” and “efficient allocation of capital.”  (Of course, I’ve also heard my economists engage in arcane legal discussions, so language barriers are dropping on both sides!)  But nothing brings greater satisfaction than hearing someone simply say, “Just call DERA.” 

Of course this means that DERA has had to up its game as well.  It’s all well and good to sit in an ivory tower and talk about economic effects in the abstract.  It’s another matter entirely to translate what we studied in graduate school into grounded and meaningful work that directly responds to the hard questions the Commission faces.  There are a variety of ways in which we can do that.  Most obviously, we can contribute robust analyses to rule proposals and adoptions.  For example, in several releases we have worked very hard to describe in quantitative terms current market conditions.  We have analyzed the types and levels of capital-raising activities in both the public and private markets.  We have performed sophisticated and novel analyses of the credit default swap market.  And when analyzing the potential effect of our rules on efficiency, competition, and capital formation, we have sought to describe, in an even-handed manner, the economic trade-offs that often come with effective regulation. 

But that is not the only way that DERA has demonstrated the expertise of its staff.  I oversee a vibrant culture of original research.  By engaging in research on topics of interest in the Commission, my economists stay abreast of the latest techniques and approaches to economic analysis, contribute directly to the intellectual capital of the academic community regarding complex market issues, and showcase the Commission’s sophisticated understanding of the markets it regulates.  The DERA website has many white papers, working papers, and links to published articles and I certainly hope you take a quick moment to take a look. 

All of these analyses are public.  And that’s an important theme here.  Encouraging public awareness of and involvement in these economic conversations is central to DERA’s mission.  One way we are seeking to ensure public engagement throughout the rulewriting process is by, when appropriate, making analyses of particular economic issues available to the public as we refine and expand our thinking regarding a particular rule.  To illustrate our efforts in this regard, I will focus on DERA’s work to assist the Commission as it considers further money market fund reform. 

The Example of Money Market Fund Reform

As many of you may know, the Commission has been considering the question of what, if any, further reforms to money market funds may be appropriate.  As I’ll describe, this process has been marked with a high level of public engagement with relevant economic issues by DERA. 

For example, before any policy choices were even proposed, DERA staff authored a memorandum intended to assist in formulating a well-considered proposal.  That memo contained both a quantitative and qualitative analysis responding to certain questions regarding money market funds raised by Commissioners Aguilar, Paredes, and Gallagher.  Those questions focused on three issues:  (1) What were the determinants of investor behavior and its effect on MMF performance during the 2008 financial crisis; (2) What has been the effect of the 2010 money market fund reforms; and (3) How future reforms might affect the demand for investments in money market fund substitutes and the implications for investors, financial institutions, corporate borrowers, municipalities, and states that sell their debt to money market funds.[2]  That staff memorandum, which was made public, helped inform the subsequent proposal. 

Now let’s turn to the proposal itself.  The proposing release itself exemplifies the way that the Commission, rulewriters, and economists are working closely together to develop rule releases.  The proposal contained a fully integrated qualitative and quantitative analysis.  For example, the release contained an analysis of the economics of money market funds, including the combination of MMF features that may create an incentive for their shareholders to redeem shares in periods of financial stress.  The release considered the economic consequences of a floating NAV and liquidity fees and gates as well as effects on efficiency, competition, and capital formation.  And we examined the potential implications of these proposals on current investments in money market funds and on the short-term financing markets.  The analyses indicated, in part, that the economic implications of the floating NAV and liquidity fees and gates proposals depend on investors' preferences, and the attractiveness of investment alternatives. 

DERA also placed additional data analyses into the comment file as part of the proposal process.  For example, one of the many issues that the Commission thought through as part of the proposal is determining the appropriate size of diversification limits in money market funds.  To assist the Commission and to inform the public, DERA staff developed memoranda that quantitatively evaluated the exposure and concentration money market fund portfolios have to the parent companies of guarantors and the parent companies of issuers.^[3]  Those memos were included in the public comment file. 

Moreover, as I mentioned earlier, DERA has a strong research program designed to focus on issues of importance to the Commission.  Flowing from my work on the money market fund release, I have authored a working paper entitled, The Economic Implications of Money Market Fund Capital Buffers.^[4]  That working paper has more recently been included in the public comment file.  I’ll briefly describe its principal findings.  If one considers the possible rationales for employing a capital buffer, which was discussed but ultimately not proposed by the Commission, one possible objective is to protect shareholders from losses related to defaults in concentrated positions, such as the one experienced by the Reserve Primary Fund following the Lehman Brothers bankruptcy.  If complete loss absorption is the objective, a substantial buffer would be required.  For example, it has been suggested that a 3% buffer would accommodate all but extremely large losses.  While such a capital buffer could make a money market fund better able to withstand significant credit events, it would be a costly mechanism from the perspective of the opportunity cost of capital because those contributing to the buffer would deploy valuable scarce resources that are being used elsewhere in presumably more valuable opportunities. 

Moreover, a basic precept of financial economics is that rational investors demand compensation for bearing risk. Since a capital buffer is designed to absorb the risk associated with credit events, it follows that those investors contributing funds to a capital buffer will demand compensation for bearing this risk.  My paper illustrates that to the extent a capital buffer could insulate money market fund shareholders from adverse credit events, it would have the additional result that money market funds would only be able to offer shareholders returns that mimic those available for government securities, thus effectively converting prime money market funds into “synthetic” Treasury funds. 

Looking Ahead to Further Conversations

So now the question is why does any of this matter to you?  Why should you care about a simple memorandum on economic analysis authored two years ago?  Of course, I imagine that some of you might be interested in the outcome of the Commission’s consideration of money market fund reform.  And so at a minimum I hope you can see how much significant, rigorous thought has already gone into that process.  But beyond this single rule, I challenge you to become an active part of the Commission’s engagement with economic thought. 

As I have described, the Commission and staff are exploring different ways to demonstrate publicly our thinking on various issues.  We will continue to have robust and transparent analyses in rule proposals.  And importantly, we will continue, as appropriate, to put additional analyses into the comment files.  Thus, the most obvious way you can become part of this is through engagement in the comment process.  I have said this in many settings and I will say it again – I encourage you to submit comment letters that contain robust qualitative and quantitative economic analyses of our rules. 

I too often read a comment letter that engages only with the policy discussions in a rule and see a missed opportunity to respond to the entirety of the rule release.  The economic analyses that are crafted as part of the Commission’s rule releases are not simple tabular accountings of costs and benefits that are after-the-fact calculations and monetizations of the effects of our rules.  They are wide-ranging, sophisticated analyses that reflect months (or maybe years) of engagement among DERA, the rulewriting staff, the Office of the General Counsel, and the Commissioners.  They animate and fully explain the Commission’s thinking on particular policy choices.  When commenters offer a rigorous and full engagement with the economic analysis – and I don’t mean with a throw-away line about benefits or burdens – it helps to ensure that the public is fully engaged in the same, economically driven discourse that is flourishing within the walls of the SEC.  And the end results of that conversation can only be positive for investors and our markets. 

Again, thank you so much for having me here today.