ANALYZE AND DISCUSS THE DIFFERENCES BETWEEN PRINCIPLES AND RULES BASED REGULATION. IN YOUR OPINION WHICH REGULATORY APPROACH IS MORE LIKELY TO LEAD TO GREATER MANAGEMENT OF CONDUCT RISK?
Analyzing and discussing the differences between Principles and Rules based regulation
The development in the internal market legislation was regarding the supervision and regulation of the financial services in 2009. The European financial crises and the decline after Great depression caused the severe backlash from the public on the financial institutions and more specifically on the banks. Even though the efficient management and regulation of risk in future scenarios of the financial sectors is still a fantasy, the governments have started looking, individually and collectively, at the creation and reinforcement of the mechanisms that will aid in the decline in the risk of future burden of systematic collapse and bank failures on taxpayers and governments (Buckley & Howarth, 2010, p.128).
The turmoil spread over the financial markets has caused the regulators, policy makers, supervisors and the general public to question the effectiveness of the financial supervision and whether the model needs changes. This ritual for reassessment is not new; every crisis is followed by reforms aiming to find a model which is optimal. The research, based on the cross-section of the financial regulatory approaches of 17 selected regulations, emerging economies, and markets, the strengths, and weakness of each model was evaluated in the research. The research found that the financial regulations should be able to achieve the policy goals of 1) mitigation of systematic risk, 2) soundness and safety of institutions, 3) and fairness of market 4) and protection of investors and customers.
The four models who have been adopted worldwide can be divided as the
- The functional approach
- The institutional approach
- The integrated approach
- The twin peaks approach
Practically, there is a no purer example of a model available as all countries and regulatory bodies adopt a combination of these approaches (Group of Thirty, 2008).
The European Union has long been an important part of the international financial governance. The agency has been showing its preferences on the application of standards and its settings in the past. The adoption of the IFRS showed its clash and diluted the dominance of the US GAAP (Moloney, 2017, p.144).
The regulations related to whichever model have repercussions in many areas. By law, accounting models, auditing, financial markets, and compliance systems for global companies, the preference for the two broadly categorized systems; principle-based or rule-based regulations impact on their adherence to the systems and their efficiency. With the deepening of the global recession; the financial institution’s structures and their legal principles applied are of main concern to the investors. The financial market regulations are debated to be based on principle-based regulations. Principle-based model refers to the wide set of the principles that provides a course for some desired outcomes. Principles or standards go along with the guidelines on how to attain the desired result (Anand, 2017). On the other hand, the rule-based regulations are based on the detail rules which govern the behavior of the firms. The rule-based regulations provide the firms with the “tick-the-box” approach for complete compliance with the law.
Over the last period, the dramatic expansion of risk in unprecedented terms has made the global business environment more complicated. With this speed in the transformation and addition of new categories of risk, the durability of the global companies and their license for operations has been threatened (McEnroe & Sullivan, 2013). For remaining competitive and relevant in this environment, the companies need to go beyond product and service innovation and pioneer thinking. They need to incorporate development and active management of the social value proposition. They should also employ in the designing and engineering of the compliance systems. More importantly, these companies must also deliver the incentives which take root in the culture which are defined by the integrity. These steps, in a high-risk environment, would forge the environment for adaptability and safety (Quaglia, 2012, p.522).
With the rise in the risk environment globally, the importance of the corporate reputation has also raised as a strategic risk and strategic asset. A survey conducted has shown that seven out of eight executives consider the reputation risk as the most critical challenge, the drivers for these risks involve the ethics, integrity, cyber security, and physical security, products, and services related issues. It is evident that the global companies usually lack the appropriate mindset and agility for coping with the risks and its underlying drivers with alacrity. The dependence on the rules-based compliance only compounds the effects in the management of risk. The situations which provide incentives at the expense of legal, political, and regulatory constraints have moral and ethical consequences.
As per scholars, the rule-based regulations possess greater hidden costs as compared to the other regulatory systems preventing the maximum compliance for economic efficiency. The rule-based systems also additionally pose design challenges. The under or over-inclusive nature of this system makes it unsustainable as the global risks have become more qualitative and fragmented in nature (Fitzgerald, 2018).
The increased debate over this topic has pushed the analysts more towards principle-based regulation. However, there are certainly many improvement areas in it as well for making it more efficient and effective.
Rules and principles tend to be proliferating as well as they both are open to and depends on their interpretation. Thus increasing novel situations create more and more guidance for the interpretation of the rules and principles increasing the sheer size of the rulebooks. These rules are becoming reluctant, inefficient, impossible to police completely, and counterproductive calls for its removal or consideration for changing. And until that time a great deal of damage is usually already done.
The proponents of the principle based method have the viewpoints that it is effective more as compared to the rules-based system because of it providing the guidance for infinite variations which arise during its practice. They also argue that it can better cope with the constantly changing modern business environment. The proponent believes that the principle-based regulation method prevents developing a box-ticking or mechanistic approach towards decision process and discourages the utilization of loophole for better observance with the given direction.
The rules-based regulation proponents, on the other hand, argue that the compliance is easier with such direct guidelines and as the requirements are prescriptive, it does not lead to any ambiguity and misunderstanding. The rules-based approach is also considered to be easier for the two to enforce as well (Icaew.com, 2010).
In fact, as discussed, most of the regulatory systems contain a system dependent on a combination of both. Rules tend to become more like principles with the addition of exceptions and qualifications. Similarly, the principles may tend to seem like rules because of the addition of requirements and best practices. The analysts have thus shown that every system of regulation would be based on somewhere along the spectrum of principles and rules, the main aim is to look for the sweet spot or the balance on this spectrum (Burgemeestre et al., 2009).
However, even if one is forced to choose one method from the two of these, it would certainly be the principle-based approach. A study has shown that the principle-based standards are more flexible and the rules-based approach may aid in the protection of the auditors against the litigation as they would have followed the rules.
Greater Model for Managing Conduct Risk:
In the last few years, the focus on the prudential regulatory matters has been increased in the financial sector. In the past, regulators would prefer to protect the interests of the customer by focusing mainly on the financial soundness of the company. However, the focus on the conduct of business practices has increased substantially, making sure that the companies are operating as per the customer interests.
The International Association of Insurance Supervisors states that the supervision of the conduct of business needs considerable highlight on principles, governance frameworks, and outcomes over and above the norm of compliance with specific rules. It is similar to the financial services industry as well. The conduct of business risk is defined as the risk to insurers, customers, a financial market, which arises from the companies, or intermediaries conducting business in a way which does not ensure the fair treatment of customers (Murray & Phelan, 2017).
When Tony Hayward was appointed the Executive of BP, he established many new rules and vowed to make safety his priority. However, the Deepwater Horizon oil rig explosion happened after it and was considered as the worst human-made disaster identified with the management failed to cripple the ability to identify risks, communicate, evaluate, and address it. This story reflects the same problem which is faced by many companies and financial institutions around the world. Even with the entire money and rhetoric spend on it; the risk model is often considered as more of a compliance problem which can be resolved by more making up of rules. Even though these regulations are reasonable and do diminish some risks that can harm a company. However, rules-based risk model cannot aid in the reduction of the probability or the effect of a failure like the Deepwater Horizon as it also did not put a stop to the collapse of the financial institutions in the 2008 financial crisis.
There are some risks which can be handled through the rules-based regulations and then there are others which need alternative models. The 3categories of the risks, the preventable risks, and External Risks and strategy risks are found not to be completely mitigated by the rule-based approach. The preventive risks are internal risks which are controllable and can be avoided through active prevention. The strategy risks are the outcomes of adopting strategies for high returns like the credit risk. Strategy risks cannot be mitigated through the rule-based model, but, a model developed to diminish the likelihood of the materializing of risks is needed. The External risks are the ones which are beyond the influence and control of the company. These risks cannot be mitigated by a compliance-based approach (Kaplan & Mikes, 2012).
Study has also shown that the disadvantage of the rules-based approach which increased the cost of operating a business, shadows the elements of corporate governance, increase dependency, and can result in legal absolutism. The study has shown that a balance between the rules and principle-based regulations are the way forward. Governance means adherence to the principles and not only rules. The paper suggests the development of risk-based approach which uses principle driven rules through dialectic reasoning (Arjoon, 2006).
Rule and compliance, thus cannot mitigate all critical risks. The principle-based regulatory system along with active as well as cost-effective risk management system requires the management to think more systematically about the various risks which they may cater to institute appropriate process. These systems will help neutralize the bias of managers to see the situation as they like it, as compared to seeing it as it actually can become.
References
Anand, A., 2017. Is the World Better Prepared for the Next Financial Crisis? [Online] Available at: https://www.law.utoronto.ca/blog/faculty/there-world-better-prepared-next-financial-crisis [Accessed 19 May 2018].
Arjoon, S., 2006. Striking a Balance Between Rules and Principles-based Approaches for Effective Governance: A Risks-based Approach. Journal of Business Ethics, 68(1), pp.53-82.
Buckley, J. & Howarth, D., 2010. Internal Market: Gesture Politics? Explaining the EU’s Response to the Financial Crisis. Journal of Common Market Studies, 48(1), pp.119-41.
Burgemeestre, B., Hulstijn, J. & Tan, Y.-H., 2009. Rule-based versus Principle-based Regulatory Compliance. [Online] Available at: https://www.researchgate.net/publication/220809898_Rule-based_versus_Principle-based_Regulatory_Compliance [Accessed 19 May 2018].
Fitzgerald, S., 2018. The Reform of Financial Supervision in Europe. [Online] Available at: https://www.iiea.com/publication/the-reform-of-financial-supervision-in-europe/ [Accessed 20 May 2018].
Group of Thirty, 2008. The structure of Financial Supervision Approaches and Challenges in a Global Marketplace. [Online] Available at: http://group30.org/images/uploads/publications/G30_StructureFinancialSupervision2008.pdf [Accessed 20 May 2018].
Icaew.com, 2010. Principles versus Rules Debate. [Online] Available at: https://www.icaew.com/technical/ethics/ethics-in-business/general-ethics/principles-versus-rules-debate [Accessed 18 May 2018].
Kaplan, R.S. & Mikes, A., 2012. Managing Risks: A New Framework. Harvard Business Review.
McEnroe, J.E. & Sullivan, M., 2013. An examination of the perceptions of auditors and chief financial officers regarding principles versus rules-based accounting standards. Research in Accounting Regulation, 25(2), pp.196-207.
Moloney, N., 2017. The European Union in international financial governance. RSF: Russell Sage Foundation Journal of the Social Sciences, 3(1), pp.138-52.
Murray, K. & Phelan, E., 2017. In Your Opinion Which Regulatory Approach Is More Likely To Lead To Greater Management Of Conduct Risk? [Online] Available at: http://www.milliman.com/uploadedFiles/insight/2017/global-developments-conduct-risk-management.pdf [Accessed 24 May 2018].
Quaglia, L., 2012. The ‘Old’ and ‘New’ Politics of Financial Services Regulation in the European Union. New Political Economy, 17(4), pp.515-35.
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