Editorial

Citation

McDonald, O. (2007), "Editorial", Journal of Financial Regulation and Compliance, Vol. 15 No. 1. https://doi.org/10.1108/jfrc.2007.31115aaa.001

Editorial

Once again the issue of principles versus rules-based regulation has raised its head, and not only in the UK. John Tiner, chief executive of the Financial Services Authority, set out his stall in a speech in March this year. Principles-based regulation, he claims, is not new. The eleven high level principles have been in existence since 2001. In fact, high level principles have a longer history than that. The notion that regulation can depend on the enunciation of principles and the companies and their staff will be able to determine how they should act on that basis in relation to customers, clients and the proper management of their businesses. When Sir David Walker became Chairman of the Securities and Investments Board, the precursor of the FSA, he found that he had inherited a detailed set of rules, the bequest of his predecessor, Sir Kenneth Berrill. A fresh start was required, so the Principles was drawn up, and later revised to reappear as the high-level principles for the FSA.

But, John Tiner points out, despite the fact that these Principles have been in place since the FSA was created, “we have all lived with a rather unsatisfactory hybrid of thousands of detailed rules, which sometimes prescribe requirements at a great level of minutiae sitting underneath these high level principles, which I would emphasise are rules in their own right”. He went on to add, “We believe that providing firms with the flexibility to more often decide for themselves what business processes and controls should operate so compliance with the principles is secured, will better align good regulation with good business practice”. And so the pendulum swings back to principle-based regulation again. Since, the UK is a member of the European Union, it is bound to implement the Directives, which constitute the single market in financial services, and, of these the latest directive (MIFID) will give rise to complex rules. The conversion to principles-based regulation is not entirely in his hands.

The UK is not alone in this trend. The USA is looking at its own rules and regulations, especially regarding the impact of Sarbanes-Oxley and in particular, Section 404 concerning internal company control provisions, or at least the way in which it has been implemented. The real problem lies in the Auditing Standard No 2, the 180-page guidance issued by the Public Company Accounting Standard Oversight Board, which leads accountants to ask for all kinds of proof, such as asking executives to prove that all their physical keys for their company's office in Europe had been accounted for since it opened in 1995! Sarbanes Oxley (or Sarbox) is part of the listing requirements for companies choosing to list on the New York Stock Exchange. It is not just Sarbox, but it is the fact that the structure of US legislation with its roots in the rules-based securities laws of the 1930s. That's not the only problem for the US. It has more multiple enforcement agencies, overlapping regulations and an extremely litigious environment as well as much more vigorous competition from elsewhere. The split between the securities regulator (SEC) for stocks and options, and futures, regulated by the Commodities Futures Exchange Commission- a dichotomy, which is increasingly out-of-date. Anxieties about losing out to the competition are driving calls for change.

It is, however, unlikely that the US regulators will move quickly to principles-based regulation. It is regarded as being too subjective, an insecure basis to regulators to operate when it comes to enforcement. They require more certainty than that when faced with litigious regulated companies. UK regulators do not operate in the same climate, but seem to have given little attention to the need for clarity and uniformity of interpretation especially when dealing with retail customers. One advantage of detailed records and rules is that the other layers of consumer protection, the Financial Ombudsman Service and the last resort, the Financial Services Compensation Scheme have a set of identifiable rules. The FSA comments that the they do not believe that they do not think that there principles-based regime will significantly affect the FOS's approach, since the FOS has to judge complaints by reference to what is fair and reasonable in all the circumstances of the case, taking into account regulations, rules and guidance, relevant codes of practice and industry good practice prevailing at the time. It is not, however, quite as simple as that. The FOS may have a very large number of complaints regarding retail investments involving banks, insurance companies and independent financial advisers and it will be difficult to make consistent decisions without rules and even more difficult to issue Guidance Notes, which are much less general that statements of principle, as the FOS does. It will be much more difficult for the Ombudsman to make not only appropriate but also defensible decisions, especially important since its determination of what is “fair and reasonable” in individual cases could have wider implications in the sort of interpretive dialogue that the FSA envisages.

The dialogue that the FSA envisages is one in which, once the FSA has cut out much of the rule-book and left firms to consider how they interpret the high-level rules and apply them to individual circumstances, so that firms will have to discuss these amongst themselves and then with each other. This is the interpretive community the FSA envisages. Firms will first of all have to provide their own detailed rule books. They are supposed to consult with each other and will look to their trade associations for further guidance. Trade associations do now provide their members with regulatory information, research back-up, track the development of EU Directives, whilst lobbying to influence the Commission and the European Parliament on the implications of proposed directives or amendments for their business. They may well be reluctant to become quasi self-regulatory organisations, quite apart from the fact that the industry view may not be to the benefit of consumers. Many practitioners have participated in work-shops to determine what “treating customers fairly” might mean and have found the process frustrating with variable outcomes and lack of clarity.

The pendulum has swung away from rules. What should really happen is not that the pendulum should swing back to mountains of detailed rules, but rather that it should stop half-way. This, however, would require strenuous detailed work with input from practitioners in order to scrutinise each rule and determine its justification. The question in each case would be: does this rule help to ensure that the firm does meet the standards set out in the high-level principles in all the ways it conducts its business with its clients or its customers? Will following this rule ensure that the company has appropriate controls in place and that it manages its risks appropriately? FSA staff would then have to have the ability to exercise proper judgement about what is important when conducting supervisory visits and taking enforcement actions. The FSA has just made its task much more difficult-and more risky.

Oonagh McDonald