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Emerald Group Publishing Limited
Copyright © 2008, Emerald Group Publishing Limited
The Financial Services Authority is once again seeking to put in place a different approach to financial regulation: the principles-based approach. Senior regulators have set out the reasons in a series of speeches. The principles cover various issues, such as integrity, skill, financial prudence, and management of the conflicts of interest. Most of the reasons offered are familiar enough. They want to focus on the outcomes that matter, such as the outcomes for consumers, investors and markets. It is hoped that these principles will be more successful in delivering these objectives; in particular, by emphasizing the responsibility of senior management to make sure that their firms live up to these principles:
“We want the senior management of firms to develop a greater understanding of these Principles and our other high level requirements should apply in practice; to drive and embed change throughout their firms; and to measure that it is delivering the right outcomes.”
Then it is thought that this approach facilitates the emergence of market-led solutions, allowing the regulator to work together with the industry, consumer bodies and other stakeholders to get solutions that really work. But the regulators have quite properly consulted with the industry and consumer bodies throughout its history and this has led to some positive results over time. There is no reason to believe that rules stand in the way.
But, it is argued that detailed rules have not achieved what they were supposed to achieve and cannot cover all circumstances and eventualities. Rules are not responsive to changes in market conditions, address processes and can encourage a narrow approach to compliance. They cite the “treating customers fairly approach” and the work with the industry to which that has led. It is true that staff of the FSA and industry have spent many hours considering various scenarios but with little effect.
I have been involved in financial regulation for the past 20 years in the UK, and before that I led for the opposition on all the bills on financial regulation as they progressed through parliament during the 1980s. The emphasis on rules and then on principles has all happened before, especially during the lifetime of the financial regulation here, first under the 1986 Act. Under the chairmanship of Sir Kenneth Berrill, it came under criticism for overly detailed and extensive rules, perhaps because the industry faced effective regulation in effect for the first time.
Sir Kenneth Berrill was followed by Sir David Walker as chairman of the Securities and Investments Board, the senior financial regulator, overseeing other regulatory bodies such as the Personal Investment Authority and the Investment Management Regulatory Organisation. He was the first to introduce the principles, 11 in all, which are still part of the regulatory framework on the Financial Services Authority, which, as a result of the Financial Services and Markets Act, took over the regulation of all sectors of the industry, including banking supervision. The principles were insufficient to guide senior management, as the collapse of Barings in 1995 showed. That led to the introduction of an emphasis on senior management responsibility with a full explanation of what that would mean in terms of more specific guidance for the conduct of senior managers.
This is a good illustration of the difficulties of relying on principles alone. It does raise the question of how senior managers exercise that responsibility and the processes which are necessarily in place; otherwise those responsibilities could not be exercised; to take a simple example, who reports what to whom and how frequently and if the reports cause anxiety and indicate irregularities, what action is the senior manager empowered to undertake. The regulator should have a clear picture of management structure and how that operates. That inevitably means that the regulator must apply certain specific requirements to the firm's management model, even though that can allow for different structures and a firm specific distribution of responsibilities amongst senior managers.
The general nature of principles makes it very difficult for staff at various levels to know what it is they are expected to do. The existence of rules and required procedures does make it possible for compliance staff to determine where problems may lie; indeed, flouting the specific rules more often than not makes it clear to compliance staff that much more serious problems are present. Of course, box-ticking and blind adherence to rules for their own sake are risks in this approach. But principle-based regulation can generate its own problems, particularly relating to compensation, depending as it often does on negligence. Enforcement actions depend on being able to demonstrate what the company or individuals within the company did wrong, but dependence on general principles may make the action difficult to justify.
Reliance on principles often goes in tandem with risk-based supervision, which the FSA has taken a lead in developing. There is much to be said for the approach, but it has its dangers, as the contributors to the journal in connection Northern Rock have pointed out. The model involving low probability-high impact does tend to induce “disaster myopia” for both regulators and the company concerned, since the cost of preparation for it is too high for the company and may well seem too remote for regulators to contemplate. Nor did the regulators understand the “aggressive nature” of the business model Northern Rock adopted. There is another danger with the risk-based model of supervision. It is also designed to enable the regulators to prioritize supervisory visits, having assessed the risks inherent in the management and business of the authorized companies. But that has its risks as well; senior managers move and the ethos of a company can change quite quickly, and, as in the case of Northern Rock, the business environment changes rapidly and its implications may not be immediately clear.
What should the approach to regulation be? Rules or principles? Risk-based supervision or continuous monitoring? The answer lies in the combination of principles and rules. Rules will only have a valuable and indeed, essential role to play if they are clearly derived from the principles and objectives of regulation and are seen to promote those aims and exemplify the principles. That should lie behind the introduction of new rules and guidance. It should also form the nature of the training given to all staff, so that they know not only what to do but why to do it. Risk-based supervision has to be combined with thorough monitoring. It is impossible to assess the risks of the firm and its models without assessing the quality of the staff and the senior management in particular. Successful regulation is more than all the techniques and the policies the regulator develops in partnership with the industry as well, it requires a “nose” as well, which alerts the regulator to the threat of regulatory failures as well.
This is my last editorial for the journal, as I am handing over to another editor, whom I am sure will develop the journal further. It has been fascinating, reading so many articles with so many different insights and information, sometimes produced after cajoling the authors to produce their work on time. Thank you for your support over the years.