On Experimentation and Real Options in Financial Regulation

AbstractFinancial regulators have recently faced enhanced judicial scrutiny of their cost-benefit analysis (CBA) in advance of significant reforms. One facet of this scrutiny is judicial skepticism toward experimentation (and the real option to abandon) in the CBA calculus. That is, agencies have arguably been discouraged from counting as a benefit the value of information obtained through adopting new regulations on a provisional basis, with an option to revert to the status quo in the future. We study field experimentation versus more conventional forms of CBA (or analytic learning) in a regulatory-judicial hierarchical model. We demonstrate that there is no principled basis for dismissing (or demoting) experimentalism and that such rationales deserve a place in agencies’ standard CBA arsenals. Nevertheless, our analysis also reveals an institutional reason for the tension between the judiciary and regulators, suggesting that regulators are plausibly too eager to embrace field experimentation while judg...