The US world of business regulation is run by lawyers, and lawyers it is said, like rules. They are clear, and they encourage innovation, because anything not strictly forbidden by a rule is deemed to be okay. In the UK, and in many other jurisdictions around the world, the preference is for principles. American business has traditionally turned its nose up at this approach, but attitudes are now changing.
US financial watchdogs are starting to take the view that their rules-based approach is not going to work for much longer, if indeed it works now. In recent years, the sheer volume of corporate rules and regulations created in the US has grown enormously. Partly that is a response to financial scandals such as Enron, WorldCom and the rest. Partly it’s an effort to keep up with innovations in the financial markets, where banks and other institutions continually churn out new products that don’t look like anything else in the regulatory rulebook.
Principles-based approach
The most prominent regulator to come out in favour of principles rather than rules, is Federal Reserve Board Chairman Ben Bernanke. He used a recent speech to argue in favour of developing a UK-style, principles-based approach to US financial market regulation, rather than creating new rules for each new financial instrument or institution.
Mr Bernanke said the rapid growth of the credit derivatives market and the increasing prominence of hedge funds did not warrant specific regulation to address possible risks that they pose. “Central banks and other regulators should resist the temptation to devise ad hoc rules for each new type of financial instrument or institution,” he said. “Rather, we should strive to develop common, principles-based policy responses that can be applied consistently across the financial sector to meet clearly defined objectives.”
This would not be a complete U-turn for US regulators. Mr Bernanke stressed that development of a principles-based approach is consistent with recent US guidance on hedge funds, which did not call for any new regulations to mitigate potential risks that the massive pools of capital pose to the financial system and economy.
Instead, the guidance, developed by the US Treasury Department, the Federal Reserve System, the Securities and Exchange Commission and other regulators, suggested that those risks would be kept in check by market discipline, due diligence by hedge fund creditors, counterparties and pension funds, and with adequate disclosures to sophisticated investors. The hedge fund guidance makes it clear that regulators and supervisors should adopt a principles-based approach similar to that used by the Financial Services Authority, the UK’s lead financial regulator, with a supervisory focus on the areas with the biggest potential risks. He said the guidance emphasised that “risks to financial stability are best addressed by focusing our attention on the large institutions at the core of the financial system.” he said a narrower approach to regulation could provide incentives for ‘regulatory arbitrage,’ driving investors to less-regulated financial instruments if rules are not applied consistently to instruments or institutions that pose risks for policy objectives.
Financial stability
Why is the US suddenly finding principles more attractive? Mr Bernanke said the biggest regulatory objectives should be ensuring financial stability, investor protection and preserving the integrity of the market. Rapid financial innovation has presented challenges to these objectives, particularly with the complexity of contemporary instruments and trading strategies, the potential for market illiquidity to magnify the riskiness of such instruments and the greater use of leverage that they often entail.
A principles-based approach would be better than ad-hoc rules for addressing such risks and taking into account financial innovations. “To avoid moral hazard and let market discipline work, investors must be allowed to bear the consequences of the decisions they make and the risks they accept. But investors are entitled to the information they need to make decisions appropriate to their personal circumstances,” he said.
The irony is that the US is being won over to principles at the same time that some in the UK are stressing the benefits of rules. The FSA is working on plans to tear up large parts of its growing rulebook, replacing prescriptive requirements with more general principles. The UK financial sector has voiced enthusiastic support. But there are doubts about whether the enthusiasm is justified. More sceptical observers say the promised benefits of this fundamental change could prove illusory.
The FSA has been experimenting with a principles-based approach to regulation for at least two years. In April it outlined plans to make a more radical switch to principles. In a paper called ‘Principles-Based Regulation,’ focusing on the outcomes that matter, the regulator said its approach to supervision would be more “outcome-focused” in future.
The FSA says it will have reassessed 80 percent of the rules in its regulatory handbook by the end of next year to see which ones it can replace with principles. Some rules will have to remain, as they are dictated by the European Union, and it has refused to hint at how many will go.
Business requirements
The idea is that by removing as many of the rules as it can, the FSA will give firms more choice about how they meet outcomes set by the regulator. For some, that means they will be able to bring their compliance work more closely into line with their business requirements.
The FSA says that well controlled and managed firms that “engage positively and openly with us” should experience real benefits in the form of what it calls a regulatory dividend. “No longer will regulation be seen as a side-line occupation that imposes costs in >> >> addition and in parallel to business costs,” its paper proclaims.
Another reason for the shift to more principles is that the FSA wants to push responsibility for compliance higher up organisations. In a prescriptive regime with thousands of rules, compliance requirements are beyond the understanding of senior managers at many firms, and can be “bewildering” for smaller firms, says the FSA. By focusing on outcomes and principles instead, the FSA expects to see key regulatory decisions taken at a more senior level, with heavy involvement from the board of directors. “This will mean a significant change in behaviour and management attention for many people in financial services firms,” it says.
FSA Chief Executive John Tiner described the shift to principles as, “the natural next step in the evolution of our regulatory system,” when he launched the paper at an industry conference in April. Financial sector organisations were quick to support the FSA’s view that a shift to principles would help lift the compliance burden. The Association of British Insurers said it backed the principles approach. The Financial Services Practitioner Panel also welcomed the FSA paper. “This is an ambitious undertaking for all concerned,” says Ron Leighton, its chairman. There are big challenges in making the switch to the new approach, but “the potential benefits of doing so are significant,” he added.
Others in the industry are less enthusiastic. Rachel Kent, head of the financial services team at lawyers Lovells, questions whether the benefits that the FSA foresees might prove illusory. “I don’t think this will reduce the compliance burden at all,” she says. “In fact, I think it will increase it.”
Ms Kent sees several reasons for questioning whether either financial firms or the FSA can successfully manage the shift to principles-based regulation. It will require a great deal of work on both sides, and she is not sure either can pull it off.
Framework of processes
A prescriptive regime has benefits for firms, she says. Not least, it gives them a degree of certainty about what they should be doing, and a framework of processes to follow. If the regulator does not provide those rules on a plate, many firms will have to write their own internal rulebooks, says Ms Kent. If they do that properly, they will be able to operate in line with rules and controls that suit their business better than the FSA’s generic handbook. “But there is a risk, particularly among smaller organisations, that they will not be able to put in the hard work required.”
To provide certainty in the absence of FSA rules, Kent expects other financial sector bodies to publish their own guidance, which the FSA will endorse. “We will end up with a proliferation of secondary level rules and guidance to fill the gaps,” she says, making the regulatory map more complex, not less.
Kent points to the Treating Customers Fairly project, the regulator’s first big attempt to make its principles-based approach a reality. It has avoided creating detailed rules on how firms should treat customers, but has published reams of discussion papers, policy statements and speeches from its senior staff, all of which provide information about how to understand its principles. “Are we now regulated by speeches?” asks Kent. “I don’t think that’s very satisfactory.”
Her biggest concern is that the FSA will use unfair hindsight when it considers enforcement action. Instead of looking at whether a firm broke the rules, it will have to decide whether, at the time an action was taken, it contravened a principle. The regulator says it will only take action if it should have been clear at the time a firm was doing something wrong. “As a lawyer, that makes me breathe a sigh of relief,” says Kent. “But I wonder how it will work.” Combined with a desire to push compliance higher up the organisation, and to try to hold individual executives accountable, “that gives rise to a bit of a worrying cocktail.”
Clifford Smout, a principal in the financial services advisory group at consultants Deloitte, says the new strategy will have important implications for compliance functions. “Implementing these changes effectively will be a real challenge and, in some cases, will require a transformation of the compliance function,” he says. “If it is going to work properly, it is going to require much more active engagement between compliance and senior management.”
Rather than saying whether an action breaks the rules or not, compliance functions will have to find ways of measuring the extent to which a firm is achieving the outcomes set by the regulator, says Smout. They will also have to learn how to manage and archive knowledge, so that if the regulator challenges an action, the firm can demonstrate that it was in line with the principles, based on what it knew at the time.
Those are all very difficult challenges. Of course, if US financial companies do find their regulators going down the principles road, and they have to write their own internal rulebooks, to make up for those that their regulators once provided, who will they turn to? Their lawyers. Maybe that’s one reason why the business establishment is warming to the idea.
