FUNDAMENTALS OF FINANCIAL MARKET REGULATION

PRINCIPLES VS. RULES - BASED REGULATION

OUTLINE

• Introduction

• Rules-based approach

• Principles-based approach

• Paradoxes

• Résumé

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Kaja Jankowska, Behzod Alimov, Susanne Ipser 2

MOTIVATION

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INTRODUCTION

Rules based regulation:

Based on a set of detailed rules that govern firms’ behavior.

Such rules enable firms to “tick-the-box” to guarantee compliance with law.

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INTRODUCTION

Principles based regulation:

Refers to a broad set of standards that gesture in the direction of certain desired outcomes.

These standards may be accompanied by guidelines about how to achieve the outcomes.

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INTRODUCTION

Reality:

Common law legal regimes are comprised of both principles and rules!

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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

• 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.

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THE PRINCIPLES-BASED APPROACH

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„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“.

- Hector Sants, the FSA Chief Executive

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:

„Do not drive faster than is reasonable and prudent in all the circumstances”

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THE PRINCIPLES-BASED APPROACH

THE PRINCIPLES-BASED APROACH

Another example:

American football

vs.

European football

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THE PRINCIPLES-BASED 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.

…

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.

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THE RULES-BASED APPROACH

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Advantages:

• Clarity and certainty

• Transparency for bank managers

• More operational than principles

THE RULES-BASED APPROACH

Disadvantages:

• High compliance costs

• Initiative and innovation depressed

• Excessive litigation

• Capital markets less attractive to investors

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THE PRINCIPLES-BASED APPROACH

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Advantages:

• Flexibility and greater freedom for managers

• Productive dialogue between supervisor and supervised

• Scalability

• Robustness

THE PRINCIPLES-BASED APPROACH

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Disadvantages:

• Uncertainty

• Unpredictability

• Supervision and enforcement more challenging

PARADOXES7 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 BlackLSE Law, Society and Economy Working Papers 13/2008

PARADOXES

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Source: ”Forms and Paradoxes of Principles Based Regulation” by Julia BlackLSE Law, Society and Economy Working Papers 13/2008

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

PARADOXESCASE STUDIES:

• Enron

• Parmalat

• Energy breakdown in California

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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.

• 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!

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