Rules or principles? The other man’s regulation is always greener

A whilc back ‘principle based’ regulation was all the rage. Outcomes based regulation is another catch cry. In an interesting paper Chris Berg of the IPA argues that the ‘mega regulators’ of Australia – the ACCC, APRA and ASIC – have now carved out for themselves such discretionary power that it’s a worry. We know so little about this that he may be right. Certainly the issues he elaborates on are worth considering. But Berg is not very explicit about what the alternatives are and why they’re better. Of course he would say ‘less regulation’ and suggests that more ‘black letter’ regulation might be better than all the essentially unaccountable discretion that the mega-regulators have.

But to be convincing I think those propositions need to be argued with closely analysed examples. I don’t think Berg’s paper succeeds in doing that.

And while Chris Berg is noticing the downsides of regulation in the lucky country, James “wisdom of crowds” Surowiecki writes that things aren’t so good in the stroppy country either. (I’m talking about the US here where Hillary has just said that the US should leave no option off the table in dealing with Iran and that it could obliterate it if it nuked Israel. I guess she’s just trying to be firm and frank here. One has to do that with these kind of people.)

[T]he most interesting thing about [Paulson’s plan for reregulating financial markets] it is something subtler: a push to move from our current system of regulationoften known as rules-basedtoward a principles-based approach. In a rules-based system, lawmakers and regulators try to prescribe in great detail exactly what companies must and must not do to meet their obligations to shareholders and clients. In principles-based systems, which are more common in the U.K. and elsewhere in Europe, regulators worry less about dotted is and crossed ts, and instead evaluate companies behavior according to broad principles; the U.K.s Financial Services Authority has eleven such principles, which are often deliberately vague (A firm must observe proper standards of market conduct). This approach gives companies more leeway in dealing with investors and customersnot every company needs to follow the same rules on, say, financial reportingbut it also gives regulators more leeway in judging whether a company is really acting in the best interests of shareholders and consumers.

Surowiecki then goes on to make some interesting comments about how American football is rules based and soccer is more principles based. He is in little doubt that principles based is best. I suspect he’s right. But he doesn’t come to grips with one of principles’ principal problems – firms and particularly directors spend a lot of time trying to figure out what their responsibilities are, because under principle based regulation things are both more uncertain and more fluid – more susceptible to judicially perceived changes in social expectations. How far should Australian directors go to address various expectations for instance? It’s often not very clear.

So I think we’re broadly going in the right direction. But like choosing between different variants of capitalism, it’s difficult to be confident of what’s best.

This entry was posted in Economics and public policy, Law, regulation. Bookmark the permalink.
Subscribe
Notify of
guest
12 Comments
Oldest
Newest Most Voted
Inline Feedbacks
View all comments
Patrick
Patrick
13 years ago

Northern Rock v Bear Stearns! As you say:

its difficult to be confident of whats best.

There is the point that hedge funds seem to have largely side-stepped the mess banks have got into because they weren’t so hung up about complying with pretty deterministic capital adequacy rules.

Arguably that highlights the real regulatory dilemma in financial services, which is how to increase the scope of market regulation (ie the scope for companies to collapse without being bailed out) whilst managing the regulator’s inability to see ‘innocent’ investors cop any sort of loss. Whether there are strict rules or principles, I think the consequences are probably the most important part.

I tend to think that the best outcome is broadly what happened at Northern Rock, with the shareholders losing everything and the government taking it over – ordinarily, it should be able to sell it a profit as well. I am a little less comfortable with Bear Stearns, where the situation seems to have been more like the government helping a private firm make a windfall (although of course it may not prove to be that!).

Marks
Marks
13 years ago

I don’t think one needs to worry whether or not the US would use nukes if Iran sent a few into Isreal – the Israelis would certainly send a few back, (not to mention a couple off course to Mecca/Medina as being in the top five targets – then the fat would be in the fire). After that, whatever the US did would be academic.

I suspect that Hillary is trying to sound Presidential – you know “A Commander-in-Chief never discounts any strategic option”.

Dum dum ta dum dum ta dum ta dum ta da da! (Hail to the Chief that is)

Jennifer
13 years ago

In my experienced, principles based regulation does tend to end up in the rules being stronger. As you say, as the company try and work out what the regulator really wants (with the regulator refusing to elaborate on the principles they have espoused), the company is likely to err on the side of too much, rather than too little (capital, governance, disclosure, etc. etc).

That can be a good thing, but also makes it harder for a Board of Directors to work out how to balance shareholder vs compliance/ risk management. If a Board becomes too fearful of regulation, then the regulatory framework has added to compliance costs, albeit indirectly.

Craig Malam
Craig Malam
13 years ago

I think you might find that most proponents of principles-based regulation would say that some of the additional time spent by Boards of Directors you mention is exactly what is intended. Instead of simply ‘checking off’ their adherence to certain standards, they are asked to think about what the standards are trying to acheive. Although this might seem costly in a static sense, it could in the end be less costly when outcomes are improved. It is, of course, very hard to measure such gains since the counterfactual is next to impossible to guess.

And this is at the heart of correctly incentivising the regulator, whose performance is extremely hard to measure. As Jennifer suggests, the regulator may not provide enough guideance about about the principles it espouses. But if the regulator can be incentivised to do so, then it should rationally choose ‘enough’ guideance, leaving the Boards and compliance committees to figure out the rest, as intended.

Craig Malam
Craig Malam
13 years ago

Nicholas I guess that is the essence of what I am saying; in order to elicit the most adaptive adherence to the principles there is necessarily some uncertainty. The two cannot be apart. I appreciate lawyers might not like that, but I see this as part of their job. It is useful to have people working on formalising what can appear arbitrary, and identifying what can not be formalised. I suppose I am less worried about this becoming dysfunctional, although you have alot more experieince than me so you are probably right about the risks.

I still think the knub of the problem is to incentivise regulators in a principles-based world so that this style of regulation can reach its full potential.

The issue of eliciting the optimal amount of uncertainty from regulators, given the objectives we have, is probably a seperate matter to whether production would shift to another jurisdiction. If the objectives are the same, but achieved without uncertainty, then we ditch principles-based regulation in that instance. However if the objectives are different, then we judge whether our objectives that much better.

Craig Malam
Craig Malam
13 years ago

I suppose I am more confident about lawyers doing their jobs, which includes isolating what can be formalised into codes of practice from what can not be. You have alot more experience than me, so I am probably underestimating the risk of things becoming dysfunctional.

But I still think the adaptive responses sought under principle-based regulation cannot be obtained without some uncertainty, it just goes with the territory. And getting the right amount comes down to incentivising the regulators.

There may be jurisdictions where less uncertainty is applied, however the question is whether this represents better regulation or just different objectives.

Craig Malam
Craig Malam
13 years ago

oops, sorry everyone, machine told me the first one had not worked. Amazing how it motivates you to get straight to the point..

James Farrell
James Farrell
13 years ago

It sounds essentially the same as the ‘per se‘ vs ‘case by case’ distinction in competition law. The latter kinds of laws are supposed to focus on outcomes, so that fits.

Craig Malam
Craig Malam
13 years ago

Right. And perhaps the checks and balances we apply to principles-based regulators is similiar – it holds the regulators accountable within the reading of the applicable principle. With regulators knowing this in advance, their incentives are pretty clear, at least when their decisions are being tested. The difficulty providing them incentives happens when nothing is going wrong (economic good times), which is when their performance is hard to measure.

Dave Bath
13 years ago

On human rights (as for constitutionality) it has been suggested that high courts give “advice” on bills before they are voted on in parliaments.

Also worth looking at is the draft EU charter (which some countries mutilated/rejected as limiting the rights of politicians to do the dirty). I think it’s the best I’ve seen since such declarations were written, including rights to good administration and environmental protection. It beats the draft charter planned by the dems (see New Matilda and humanrights.com.au (supported by Mal Fraser).

Official PDF version here.

My HTML rendering and some notes here.