The British business sector has voiced enthusiastic support for the Financial Services Authority’s plans to tear up large parts of its growing rulebook, replacing prescriptive requirements with more general principles.

But is the enthusiasm justified? More skeptical observers say the promised benefits of this fundamental change could prove illusory.

The FSA has been experimenting with a principles-based approach to regulation for several years. In April, however, it outlined plans to make a more radical switch to principles. In a paper called “Principles-Based Regulation: Focusing on the Outcomes That Matter,” the regulator said its approach to supervision would be more “outcome-focused” in future.

The FSA says that by the end of next year it will reassess 80 percent of the rules in its regulatory handbook to see which ones it can replace with principles. The idea is that by removing as many of the rules as it can, the FSA will give firms more choice about how they meet outcomes set by the regulator. For some, that means they will be able to bring their compliance work more closely into line with their business requirements.

Some rules will have to remain, as they are dictated by the European Union and the FSA has refused to hint at how many will go. But the FSA says that well-controlled and managed firms that “engage positively and openly with us” should experience real benefits in the form of what it calls a regulatory dividend. “No longer will regulation be seen as a side-line occupation that imposes costs in addition and in parallel to business costs,” the FSA paper proclaims.

The FSA also hopes that a principles-based approach will push responsibility for compliance higher up companies’ organizational charts. In a prescriptive regime with thousands of rules, compliance requirements are beyond the understanding of senior managers at many firms and can be “bewildering” for smaller firms, says the FSA. By focusing on outcomes and principles instead, the agency expects key regulatory decisions to be made at a more senior level, with heavy involvement from the board of directors.

Tiner

John Tiner, the FSA’s chief executive officer, described the shift to principles as “the natural next step in the evolution of our regulatory system” when he launched the paper at an industry conference in April.

RELATED RESOURCES

Text Of FSA Report On Principles-Based Regulation (April 2007)

Committee On Capital Markets Regulation Report (11.5 MB; Nov. 30, 2006)

Briefing Papers

Back To First Principles (Deloitte)

Principles-Based Regulation: What firms should do (Freshfields Bruckhaus)

Related Coverage

Shift From Rules- To Principles-Based World (May 8, 2007)

Narrative Reporting Gets A Big Boost In UK (March 27, 2007)

Paulson Committee Ideas Unveiled (Dec. 5, 2006)

Financial sector organizations were quick to support the FSA’s view that a shift to principles will help lift the compliance burden. The Association of British Insurers said it backed the principles approach. The Financial Services Practitioner Panel also welcomed the FSA paper; its chairman, Ron Leighton, described the idea as “an ambitious undertaking for all concerned.” There are big challenges in making the switch to the new approach, but “the potential benefits of doing so are significant.”

Enter The Naysayers

Others in the industry are less enthusiastic. Rachel Kent, a partner with the Lovells law firm, questions whether the benefits that the FSA foresees might prove illusory. “I don’t think this will reduce the compliance burden at all,” she says. “In fact, I think it will increase it.”

Kent

A prescriptive regime has benefits for companies, she says. Not least, it gives them a degree of certainty about what they should be doing and a framework of processes to follow. If the regulator does not provide those rules on a plate, many firms will have to write their own internal rulebooks, says Kent. If they do that properly, they will be able to operate in line with rules and controls that suit their business better than the FSA’s generic handbook. “But there is a risk, particularly among smaller organizations, that they will not be able to put in the hard work required,” she says.

To provide certainty in the absence of FSA rules, Kent expects other financial sector bodies to publish their own guidance, which the FSA will endorse. “We will end up with a proliferation of secondary-level rules and guidance to fill the gaps,” she says. That will make the regulatory map more complex, not less, she adds.

FSA PRINCIPLES

Below is a portion of the FSA report released in April, discussing extra guidance the agency will publish to help corporate compliance.

If a firm has complied with the Principles, high-level rules and other rules, then it is irrelevant whether they have complied with any other material we have issued. But firms can rely on all the material we publish. This is fundamental to our approach. So if a firm takes a reasonable course of action which we have indicated, in general public material or in a specific individual exchange (such as a supervisory letter), as being in compliance with a rule, then we will not take action against the firm for not having complied with the rule. The status of the general public material – the process it has been through, the format in which it has been published – does not affect that. For example, it does not matter whether it is a specific rule or formal guidance in the Handbook, or a case study or ‘Dear CEO’ letter on our Web site.

The Handbook sets out the minimum acceptable standards of firm behavior and the primary function of the material we produce in support of it is to illustrate where the boundary of acceptable, compliant behavior lies. We do not require firms to go beyond this level of compliance, although many do so for commercial reasons.

Of course, discussion of good practice can and does come up in our dialogue with firms and industry sectors about firms’ behavior, and we will continue to engage with and foster this debate where we can add value. But in our discussions with, and communications to, firms about our requirements we will continue to focus on indicating where the minimum threshold of compliance lies (sometimes by pointing out good and bad practice) and to make clear that going beyond the minimum standard is a matter of commercial judgment for firms’ senior management and not a requirement of the FSA.

We will continue to exercise judgment on a case by case basis, within our legal framework, when it comes to deciding what status published material should have – that is, whether it is Handbook guidance or less formal supporting material. We will not simply issue Handbook guidance when a more dynamic approach (such as case studies or Dear CEO letters) would be more effective in achieving the outcomes we are looking for. This decision does not make a difference from a firms’ perspective to whether the material can be relied upon, but is a factor in the FSA’s consideration of how much reliance to place on such material.

Our overall objective is to help firms make decisions themselves about what business processes and controls they should have in order to meet our requirements. In considering a firm’s response to an investigation or other regulatory action we may look to material we have issued.

The status afforded to our materials may impact the weight they carry in an enforcement context. As well as consulting on guidance itself we will consider whether to undertake and consult on a cost benefit analysis of proposed guidance based on a number of factors:

where we consider our proposed guidance may materially impact market structures;

where it may change the behaviors of firms in a way which is not already accepted in the market; and

where the guidance is not reasonably predictable from the Principle (without it being a new requirement).

Otherwise we will, when required by legislation, consult on guidance but we will not necessarily include a cost benefit analysis in the consultation (as will be possible following a Regulatory Reform Order coming into force later in 2007).

Source

British Financial Services Authority (April 2007)

Kent points to the Treating Customers Fairly project, the FSA’s first big attempt to make its principles-based approach a reality. The agency has avoided creating detailed rules on how firms should treat customers, but has published reams of discussion papers, policy statements, and speeches from its senior staff, all of which provide information about how to understand its principles. “Are we now regulated by speeches?” Kent asks. “I don’t think that’s very satisfactory.”

Kent’s biggest concern is that the FSA will use hindsight unfairly when it considers enforcement action. Instead of looking at whether a firm broke the rules, it will have to decide whether, at the time an action was taken, it contravened a principle. The regulator says it will only take action if an infraction should have been clear at the time a firm was doing something wrong.

“As a lawyer, that makes me breathe a sigh of relief,” says Kent. “But I wonder how it will work.” Combined with a desire to push compliance higher up the organization and to try to hold individual executives accountable, “that gives rise to a bit of a worrying cocktail.”

Compliance With Principles

Clifford Smout, a principal in the financial services advisory group at Deloitte & Touche, says the new strategy will have important implications for compliance functions. “Implementing these changes effectively will be a real challenge and, in some cases, will require a transformation of the compliance function,” he says. “If it is going to work properly it is going to require much more active engagement between compliance and senior management.”

Rather than saying whether an action breaks the rules or not, compliance functions will have to find ways of measuring the extent to which a firm is achieving the outcomes set by the regulator, says Smout. They will also have to learn how to manage and archive knowledge, so that if the regulator challenges an action, the firm can demonstrate that it was in line with the principles, based on what it knew at the time.

Smout

Smout says it could take firms five to 10 years to transform their compliance functions in this way. Meanwhile, the skills needed are going to change. With fewer rules and less guidance, compliance functions will need to take on a more advisory role.

“The skills that you need to understand 8,500 pages of detailed guidance from the FSA are considerable, but they are different from the skills you need to advise your own senior management about whether their business model is going to cause problems for the regulator,” he says. “I see this resulting in a major upgrading in the challenge and interest of the compliance job, and something that the best people in compliance will welcome very much.”

For others it will be what Smout euphemistically calls “a developmental opportunity.” They might not survive the changeover.