Principles worth the tough slog: FSA head

By Steven Lamb | March 28, 2007 | Last updated on March 28, 2007
4 min read

The benefits of a principles-based approach to securities regulation may not be immediately clear, but such a system could be no worse than the detailed rules-based systems that have failed the markets in the past, according to John Tiner, chief executive of the UK’s Financial Services Authority.

“Regulating in a more principles-based system is no easy option. It is really very difficult,” said Tiner, speaking to a dinner audience at Toronto’s National Club and hosted by the Investment Industry Association of Canada. “It creates, I think, probably more risk to both the regulator and the regulated.”

He admits that debate is too often framed as rules versus principles, when in fact, regulators require both. But Tiner believes the balance between the two should be strongly in favour of principles. In reality, he says the FSA still has 9,000 pages of rules for the UK industry.

“I can’t prove it to you that this is a better system. I think it is a rather large act of faith,” he said. “I believe in it hugely, but the politicians at home asked me can I prove it, and the answer is no.”

Canada’s Finance Minister Jim Flaherty expressed his own belief in such a system in the 2007 federal budget, calling on Canadian regulators to get together and adopt a principles-based approach. He even cited Britain’s success with the FSA as a model which should be followed.

While the FSA has frequently been held up as a shining example of integrated and principles-based regulation, it is not without its faults, Tiner pointed out.

The FSA currently oversees as many as 29,000 different companies, ranging from securities brokers, issuers and insurers, to mortgage lenders, dentists and veterinarians.

“You must think, ‘why on Earth do they do that?’ and I ask myself the same question,” he said. “It’s one of those silly quirks of European law.”

Imagine, he explains, you are in a dentist’s waiting room and pick up a brochure on dental care insurance. If you ask the dentist about it, any advice they offer is considered a regulatory transaction.

“Obviously this has no value to anybody; it simply imposes costs on the consumer,” he said.

The goal of a regulator should be to remain largely invisible to the consumer, presenting a seamless image of a market deserving of investor confidence. Besides, he said, the average Briton is financially illiterate, so they could hardly be expected to get too involved in the debate between regulatory philosophies.

The primary benefit of using principles is that they define the outcome that society is attempting to achieve. It is difficult to argue with such principles as “treat the client fairly” or “provide clear information to customers.”

“You can very clearly express in principles what is the real purpose of regulation. It doesn’t get lost in legally written rules. That’s why I’m so very keen on principles.”

Rules-based regulation has failed repeatedly, in virtually every developed market, to prevent the problems it is intended to head off: Portus in Canada; Enron in the U.S.; an 11 billion pound pension collapse in the UK. All occurred under the supposedly watchful eye of rules-based regulatory systems.

If anything, he argues, a rules-based approach simply provides a roadmap on how to circumvent the regulatory goal of consumer protection.

There are few industries in the world that evolve more rapidly that the financial markets. The growing demand for ever more complex products – hedge funds, principal protected notes, universal life policies – makes it virtually impossible for a rules-based regulator to keep up.

“Rules are always playing quite slow catch-up with these dynamic industries, whereas principles you can work up very quickly because they go to the very spirit of the markets,” he said.

In the UK, the FSA has found it most useful to use new rules as a last resort, as Tiner said the market itself is the best regulator. When the market fails to detect a problem, the FSA will “ask” the affected industry to address the issue, and issues a timetable for a fix. The industry has generally responded well to this opportunity, Tiner said, as the alternative to solving the problem is that the FSA will impose its own “quite horrible” rule.

This approach has led to the unbundling of fees in the investment fund industry, and the timely issuance of documentation in the insurance sector.

Too often, he said, “principles-based regulation” is used interchangeably with “risk-based enforcement.” The two do work well together, but risk-based enforcement defines only how the regulator should approach industry abuses, and has little to do with how regulations are crafted.

“One term that gets used a lot about the FSA, that we try to correct at every possible opportunity, is that we are a ‘light-touch’ regulator,” he said. “Risk-based regulation is not about light-touch; it’s about being really tough when you need to be, and being quite standoff when you don’t need to be, because business runs itself very well.”

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Steven Lamb