Principles Based Regulation - let's not do that again

Imagine yourself back in the Spring of 2007. Everyone was feeling pleased with themselves. The problems with our system of capitalism had been solved. We'd outsmarted all the generations that preceded us, even the brainy ones who thought they understood the dismal science of Economics. 

The cycle of boom and bust had been abolished, through the wonders of excellent economic management. Ed Balls had been appointed City Minister the previous year. In his first speech, he promised that "nothing should be done to put at risk a light-touch, risk-based regulatory regime". The public was frolicking about in a bath of cheap debt.

Two rather different documents had just been published. The first was from the UK's Financial Services Authority. In April 2007, they produced a treatise explaining the benefits of PBR, which you can find here (FSA on PBR).  

According to the FSA: "Past experience suggests to us that prescriptive standards have been unable to prevent misconduct. The ever-expanding rule books of our predecessor bodies and our consolidated Handbook, designed to prevent misdemeanour, have not stopped further misselling, market misconduct or other detriment. Instead we believe that detailed rules have become an increasing burden on our own and the industry’s resources."  They went on to say that PBR "will allow us to deliver better regulatory outcomes in a proportionate way that is more efficient and effective."  

As we all found out in 2008, this confidence was misplaced.  Among the (perfectly good) principles set out in the FSA's document to which the regulated banks seemed unable to adhere were: 

2. A firm must conduct its business with due skill, care and diligence.

3. A firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems.
4. A firm must maintain adequate financial resource.

At this point, you might object and say that it's easy for me to demonstrate the weaknesses in the FSA's analysis with the benefit of hindsight. True enough. But it was also possible at the time and people were doing it. Time for our second document. 

In March 2007, Lawrence Cuningham, Professor of Law at George Washington University Law School, published a 30,000 word scholarly essay entitled "A Prescription to Retire the Rhetoric of 'Principles-Based Systems' in Corporate Law, Securities Regulation and Accounting."  You can download that paper here (Cunningham).  The core argument is that complex regulatory systems cannot be properly described as either "rules-based" or "principles-based". In reality, a mixture of both is required. 

In two telling passages, Cunningham writes: "Rules and principles are imperfect categories to describe individual legal or accounting provisions.  While some provisions may fit neatly into such categories, rational systems of law or accounting partake of both types and hybrids running across a continuum.  Even when it is possible to classify individual provisions as rules or principles, fairly characterizing entire systems as rules-based or principles-based is an essentially impossible task." 

He goes on to say: "If it is infeasible to establish a principles-based system of corporate law, securities regulation or accounting, then it is misleading to promote the possibility. Accordingly, the labels should be retired and regulators who use them greeted with skepticism that they are operating under unfortunate by-products of jurisdictional competition." 

And there you have it. You need broad principles and detailed rules. Without either, you're going to come unstuck. Any lawyer who'd ever studied law and equity could have told you this. You have to ask whether people were listening to the lawyers when PBR was being advertised as the cure for regulatory systems. Actually, you need to go further and ask whether anyone had ever read their Montesquieu. Whose idea was it that any single body, in any sphere of activity, should be put in charge of promulgating regulations, investigating alleged breaches of those regulations and imposing penalties for violations?

Let me close with a more homespun example. On a Saturday morning, your correspondent is often to be found wandering the aisles of his local supermarket, carefully studying a list of items provided to him by Mrs K. In a "Principles Based" world, the list would probably contain something like this: "(i) Buy things which are healthy. (ii) Buy things the kids like. (iii) Look out for special offers. (iv) Find things which are high in fibre. (v) Consider the welfare of the chickens that laid the eggs" or similar. Make up your own list. If I had a principles based shopping list, who knows what I'd actually decide to buy? 

On the other hand, a rules based shopping list would probably say "Buy 12 medium eggs". Much easier to know what to do. But if I didn't know that our household favours free range as a matter of principle, I could also buy the wrong thing. 

As a General Counsel trying to advise a company, PBR is as confusing as a principles based shopping list. Any serious system of regulation needs to contain rules and principles. If non-lawyers tell you otherwise, take on the debate. If any lawyer tells you otherwise, ask them where they went to law school and whether they can get a refund.

Next time, the previously promised post on overwork amongst lawyers. 


  1. Ahhh, thee shopping list - nice touch!

    I'm going to look up the references when I get a sec. Enforcement against principles seems to me to be pretty difficult given that the principles tend to manifest the conflicts within professional ethics rather than resolve them. That said, the rules-based approach has all the well-known problems: over and under-inclusiveness; inability to cope with 'new' problems; complexity; creative compliance, etcetera. A lot will depend on how meaningful any risk assessment is and,in particular, how effective relationship management is.

  2. Any serious system needs rules and principles and it also needs a regulator with the political will to regulate, and resources to do so. The FSA engaged in light touch regulation due to (it says) political pressure and the fear that more onerous regulation would harm competitiveness. Yet we are seeing exactly the same argument (about competitiveness) being trotted out in relation to the regulation of large law firms alongside the introduction of outcomes focussed regulation


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