FUNDAMENTALS OF FINANCIAL MARKET
REGULATION
PRINCIPLES VS.
RULES - BASED
REGULATION
OUTLINE
• Introduction
• Rules-based approach
• Principles-based approach
• Paradoxes
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Kaja Jankowska, Behzod Alimov, Susanne Ipser
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• Résumé
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MOTIVATION
INTRODUCTION
Rules based regulation:
Based on a set of detailed rules that
govern firms’ behavior.
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Such rules enable firms to “tick-the-box”
to guarantee compliance with law.
INTRODUCTION
Principles based regulation:
Refers to a broad set of standards that
gesture in the direction of certain desired
outcomes.
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These standards may be accompanied
by guidelines about how to achieve the
outcomes.
INTRODUCTION
Reality:
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Common law legal regimes are
comprised of both principles and
rules!
THE RULES-BASED
APPROACH
• Sarbanes-Oxley Act (US)
• Rules-based structure: Perceived by many as
hopelessly “complex”, “murky”, and “harder to
understand and harder to follow” than more flexible
regimes in other nations
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• BUT: According to the U.S. Treasury Secretary Henry
Paulson, the rules-based regulation has served the
United States very well over the course of its history and
is part of the foundation for its prosperity and growth.
THE PRINCIPLESBASED APPROACH
„What principles-based regulation does mean and should mean, is
moving away from prescriptive rules to a higher level of articulation of
what the FSA expects firms to do. In other words, it helps emphasise
that what really matters is not that any particular box has been ticked
but rather that when making decisions, executives know they will be
judged on the consequences – the results of those actions“.
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- Hector Sants, the FSA Chief Executive
THE PRINCIPLESBASED APPROACH
An example for the difference between rules and principles:
A rule will say:
„Do not drive faster than 90 km/h”
A principle will say:
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„Do not drive faster than is reasonable and prudent in all the
circumstances”
THE PRINCIPLESBASED APROACH
Another example:
American football
vs.
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European football
THE PRINCIPLESBASED APPROACH
The U.K. FSA’s 11 Principles for Businesses:
1. A firm must conduct its business with integrity.
2. A firm must conduct its business with due skill, care, and
diligence.
…
6. A firm must pay due regard to the interest of its customers
and treat them fairly.
…
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11. A firm must deal with its regulators in an open and
cooperative way, and must disclose to the FSA appropriately
anything relating to the firm of which the FSA would
reasonably expect notice.
THE RULES-BASED
APPROACH
Advantages:
• Clarity and certainty
• Transparency for bank managers
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• More operational than principles
THE RULES-BASED
APPROACH
Disadvantages:
• High compliance costs
• Initiative and innovation
depressed
• Excessive litigation
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• Capital markets less
attractive to investors
THE PRINCIPLESBASED APPROACH
Advantages:
• Flexibility and greater freedom for managers
• Productive dialogue between supervisor and supervised
• Scalability
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• Robustness
THE PRINCIPLESBASED APPROACH
Disadvantages:
• Uncertainty
• Unpredictability
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• Supervision and enforcement
more challenging
PARADOXES
7 paradoxes of principle based legislation:
1. THE INTERPRETIVE PARADOX:
Principles can be general yet precise
2. THE COMMUNICATIVE PARADOX:
Principles can facilitate communication but can also hinder it
3. THE COMPLIANCE PARADOX:
Principles provide scope for flexibility in compliance yet can lead to
conservative and/or uniform behaviour by regulated firms
4. THE SUPERVISORY AND ENFORCEMENT PARADOX:
Principles need enforcement to give them credibility but over- enforcemnet
can lead to their demise
Source:
”Forms and Paradoxes of Principles Based Regulation” by Julia Black
LSE Law, Society and Economy Working Papers 13/2008
PARADOXES
5. THE INTERNAL MANAGEMENT PARADOX:
PBR can provide flexibility for internal control systems to develop but
can overload them
6. THE ETHICAL PARADOX:
PBR can facilitate a more ethical approach but it could result in an
erosion of ethics
7. THE TRUST PARADOX:
PBR can give rise to relationships of trust, mutuality and
responsibility but these are the very relationships which have to exist
for it to be effective
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Source:
”Forms and Paradoxes of Principles Based Regulation” by Julia Black
LSE Law, Society and Economy Working Papers 13/2008
PARADOXES
CASE STUDIES:
•Enron
•Parmalat
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•Energy breakdown in California
RÉSUMÉ
•The rules-based approach ensures clarity and certainty,
transparency for bank managers and is more operational than
principles.
•On the other hand, it is connected with high compliance costs and
excessive litigation. Innovation may be depressed and capital
markets less attractive to investors.
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•PBR, in its full form, can provide an effective, durable,
resilient and goal based regulatory regime, but at the same
time its paradoxical nature means that it is vulnerable.
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THANK YOU FOR
YOUR ATTENTION!