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Putting Principles to the Test

August 14, 2007
By Carol E. Curtis

As markets around the world increasingly converge, the concept of principles-based regulation is moving to the forefront as a way to reform or streamline the U.S. regulatory environment. Under a principles-based approach, such as that recently put in place by the U.K.'s Financial Services Authority (FSA), regulators put the onus on private firms to decide how to reach desired outcomes, rather than relying on prescriptive sets of rules. For example, under the long-standing rules-based approach, management might be required to sample a specific number of trades. Under principles-based regulation, management could be asked to demonstrate why sampling is appropriate and would have to justify why it chose to sample a specific amount. "Globalization is a major driver of the move toward principles-based regulation," says Bill Nosal, managing director of compliance products at Wayne, Pa.-based SunGard Data Systems. "In a multi-jurisdictional environment, you reduce compliance costs by not having different sets of regulations. Bigger firms do not want the checklist approach. They want to apply a common approach around the globe."

The concept also has the backing of the Committee on Capital Markets Regulation, an independent group of business, financial, legal and accounting leaders, and Federal Reserve Board chairman Ben Bernanke has spoken favorably of it. In a May 15 speech to the Federal Reserve Bank of Atlanta's Financial Market Conference in Sea Island, Ga., he said, "We should strive to develop common, principles-based policy responses that can be applied consistently across the financial services sector to meet clearly defined objectives." But Bernanke also pointed out that the 11 fundamental principles of U.K. financial regulation are accompanied by an 8,500-page rulebook. The framework should not be considered "light touch," said Bernanke. Its effectiveness is based on "regulatory resources and attention [being] devoted to firms, markets or instruments in proportion to the perceived risks to the FSA's regulatory objectives."

U.S. Test

For new applications of principles-based regulation in the U.S., look no further than the merger of the securities industry's two principal self-regulatory organizations (SROs), NASD and NYSE Regulation, the regulatory arm of NYSE Euronext. The merged entity, dubbed the Financial Industry Regulatory Authority (Finra), will have as its initial task the creation of a single rulebook from the sets of rules followed by the predecessor SROs. "Many of the rule filings included in the harmonization filing, such as space sharing and dual employment, recommended a more principles-based approach," notes Brendan Intindola, communications manager at NYSE Regulation, adding that "any technology deployed ... would have to conform to the rules, regardless of the principle or prescriptive approaches."

It is unlikely that the industry will ever get away completely from detailed rules. As Richard Ketchum, CEO of NYSE Regulation and designated chairman of Finra, said in a March 27 speech to the Securities Industry & Financial Management Association's Compliance and Legal Conference, "Prescriptive rules were created to address specific instances of industry failure. ... The more detailed regulations reflect regulators' frustration over the industry's previous inattention to controls, and our desire to protect investors. Interestingly, it also reflected the industry's demand for specificity, driven largely by disciplinary actions, greater legal exposure and increasing penalties."

Ketchum also spoke then of the need to "find more areas to embrace more flexible risk-based rulemaking."