Rules Versus Principles Based Regulation
Which is better - rules or principles based regulation?
While in the UK principles based regulation has been around much longer, it has become more common since 2008 financial crisis. Given the focus on post-Brexit regulation now is a good time to consider if this direction of travel is appropriate, or if there is a greater role for rules based regulation.
Before we discuss the benefits and disadvantages of each, we need to define what we mean by principles based and rules based regulation.
Principles based regulation uses high-level, general statements often containing both explanations of the intent behind the principle and qualitative rather than quantitative terms (“fair”, “reasonable”). Principles are designed to be applicable across a wide range of circumstances and as used by regulators today often focus on outcomes, rather than inputs; the FCA’s Consumer Duty being a recent example.
In contrast rules based regulation uses specific statements to define requirements that firms must meet. These necessarily focus on specific areas and tend to use quantitative terms (“within 8 weeks”).
In the UK and to a lesser extent in the European Union, the trend since the 2008 financial crisis has been towards principles based regulation focused on outcomes. This has been driven by a range of factors, including a belief principles based regulation reduces the potential for ‘creative compliance’ and forces firms to consider the implementation of regulation and how it applies to their business rather than adopting a ‘tick-box approach’. Principles based regulation also has the advantage that it may not need updating as frequently to respond to new developments, for example new products - although that does require the new product to be within the regulatory perimeter as cryptocurrencies have shown.
However, before we wholeheartedly pursue principles based regulation we should understand that it has some disadvantages compared to rules based regulation:
1. Consumers cannot refer to a clear set of standards and understand what firms should be delivering.
The FCA’s complaint handling requirements in the DISP Sourcebook contain clear rules on the information that must be provided to consumers and the maximum time allowed for complaint handling before a consumer can refer the complaint to the Financial Ombudsman Service. If these were instead written as principles it would be almost impossible for a consumer, without prior knowledge or experience, to determine if their complaint had been handled in a ‘reasonable’ timeframe. To complicate matters, different firms may have different interpretations of ‘reasonable’.
2. Firms face increased challenges and costs from principles based regulation, which can in turn impact the very consumers the regulation is seeking to protect.
When new principles based regulation is issued it must be interpreted by the firm, often requiring significant time and effort from compliance, commercial teams and external legal counsel, as well as senior management. This means principles based regulation requires a longer implementation period and costs firms more to implement; costs that are likely to be passed to consumers.
The implementation process also increases interpretation risk, which regulators have tried to address via guidance, informal guidance (such as speeches) and post-implementation reviews. These again require interpretation and may result in firms incurring further costs, while still carrying interpretation risk. It also increases the risk that over time guidance becomes contradictory as new guidance is released to address specific issues, unless a holistic review is undertaken by the regulator in advance of issuing new guidance.
Principles based regulation and the accompanying suite of guidance may also stifle innovation. New firms seeking to enter a market cannot simply refer to a collated set of rules, but need to review consultation paper responses, published regulation and subsequent guidance which increases costs and risk.
3. Regulators run the risk that as they do not need to write detailed rules for different industries they, especially in their policy teams, lose detailed industry knowledge which can be so important for effective regulation.
While there is no perfect answer and each approach has its own benefits and disadvantages, perhaps it is time to reconsider whether greater use should be made of rules based regulation.
This article has been informed by the excellent paper Making a success of Principles-based regulation, Julia Black, Martyn Hopper and Christa Band, Law and Financial Markets Review, May 2007.
Do you think the UK should continue to emphasise principles-based regulation or move to embrace a more rules-based approach to regulation?