Rules and Standards When Compliance Costs Are Private Information

A regulator, seeking to maximize net benefits, must choose between rules and standards and then set a level of care. The regulated agents have private information about their compliance costs. Rules are set ex ante, so agents know the required level of care. Standards are established after agents have taken initial actions, in anticipation of the regulating bureau’s directive. Those actions allow the bureau to make inferences about agents’ costs and thus set more appropriate requirements. Standards, however, expose agents to adjustment costs when they misjudge the required level of care before it is set. Nuanced trade-offs emerge. Standards are relatively more attractive when adjustment costs are low and compliance costs are more uncertain. If some agents are large relative to the market, those agents will choose their actions strategically to influence the ultimate standard. Rules, in contrast, are immune to strategic posturing. We discuss applications to financial regulation.