1. Fundamentals of financial market regulation
principles vs. rules - based regulation

2. Outline Introduction Rules-based approach Principles-based approach
Paradoxes
Résumé
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

3. Motivation
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

4. 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.
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

5. 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.
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

6. introduction
Reality: Common law legal regimes are comprised of both principles and rules!
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

7. 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. 7
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

8. The principles-based 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“.
- Hector Sants, the FSA Chief Executive
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

9. The principles-based 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: „Do not drive faster than is reasonable and prudent in all the circumstances”
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

10. THE PRINCIPLES-BASED APROACH
Another example: American football vs. European football
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

11. The PRINCIPLES-BASED APPROACH
The U.K. FSA’s 11 Principles for Businesses:
A firm must conduct its business with integrity.
A firm must conduct its business with due skill, care, and diligence. …
A firm must pay due regard to the interest of its customers and treat them fairly.
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.
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

12. The rules-based approach
Advantages:
Clarity and certainty
Transparency for bank managers
More operational than principles
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

13. The rules-based approach
Disadvantages:
High compliance costs
Initiative and innovation depressed
Excessive litigation
Capital markets less attractive to investors
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

14. The principles-based approach
Advantages:
Flexibility and greater freedom for managers
Productive dialogue between supervisor and supervised
Scalability
Robustness
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

15. The principles-based approach
Disadvantages:
Uncertainty
Unpredictability
Supervision and enforcement more challenging
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

16. 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

17. Paradoxes 17 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
Source:
”Forms and Paradoxes of Principles Based Regulation” by Julia Black
LSE Law, Society and Economy Working Papers 13/2008 17
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser 17

18. Paradoxes CASE STUDIES: 18 Enron Parmalat
Energy breakdown in California 18
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

19. 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.
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser

20. Thank you for your attention!
03/02/2012
Kaja Jankowska, Behzod Alimov, Susanne Ipser