The functions of any financial services regulator steer around three basic pillars: regulation, supervision and enforcement. However, there are many different approaches to each one of these pillars which the regulators can choose from to create the regulatory framework. This article attempts to explain how the FSA’s chosen combo poses serious risks to the freedom of individuals and corporations in a market economy and exacerbates the potential for abuse of power by the regulator, creates legal uncertainty and compromises the values of the rule of law.
In terms of regulation (i.e. writing rules), the FSA has always favoured a ‘principles based’ and ‘outcomes focused’ methodology. In this sense, although UK’s financial regulation comprises an extensive handbook with detailed and specific rules, the jewel crown that underpin the entire framework is the 11 ‘principles for business’ that financial firms must observe. Moreover, individuals registered with the FSA as ‘approved persons’ (normally senior managers and client facing bankers) must comply with a set of 7 ‘statements of principles for approved persons’. Most of these principles for firms and individuals are extremely general and can embrace almost any activity. For example, some of these principles state that individuals and firms must act with integrity and due skill, care and diligence. This approach, which is diametrically opposed to the box-ticking, ‘rule based’ system, implemented in other countries such as the US, has also an upside as it is, to some extent, believed to be more beneficial for the financial sector as it allows a degree of freedom and flexibility for companies to decide how to achieve those outcomes and comply with the principles. However, for this methodology to work efficiently, any interference from the regulator should be kept to a minimum.
In relation to supervision of financial markets and firms, The Big Fish already explained in a previous post (in fact the very first one) how, since its inception, the FSA’s attitude has steadily changed and become a major threat to freedom of enterprise in the UK. The old FSA system of ‘light touch’ regulation is now a thing of the past and the trend is moving rapidly to the ‘more intrusive supervision’ approach spearheaded by a more powerful and determined regulator than ever before. This entails making ‘judgements on judgments’ and taking a more pro-active and pre-emptive view of regulated firms’ internal affairs.
Finally, and in parallel with the ‘more intrusive supervision’ approach, the FSA has also intensified its enforcement activity and made its ‘credible deterrence’ attitude the flagship element of its approach to enforcement. This ‘credible deterrence’ enforcement style involves the stated intention by the regulator to pursue high profile cases in specific areas of concern.
By nature, any ‘principles based regulation’ system is to some extent imprecise and has vague borders. Consequently, any action taken by a regulator on the basis of generic principles is likely to rely heavily in opinions rather than facts. On the contrary, in a rule based system, either there is a breach of a rule and it is proven so or there is not. In a principle based system it is possible that prosecution occurs if the expected outcome of a particular principle is not met up to the level the regulator wants. Indeed, if one looks at the rationale behind most enforcement actions the FSA has taken in 2011 and so far in 2012, it is palpable how the reasons supporting these fines and sanctions are increasingly based on the breach of principles only, as opposed to specific rules, or on behaviours which fall short of what the regulator expected in order to meet its desired outcomes.
Therefore, it is not surprising that, when such a vague and borderless system of principles is combined with an intensive and intrusive supervision and a prejudiced enforcement, the likelihood of the regulator to exceed and even abuse its powers increases significantly. The consequences are a potential for limitations of freedom as well as the presumption of innocence. The rule of law is likely to be strained and tainted because of sudden changes in the interpretation or implementation of these principles, normally based on the needs or interests of the regulator instead of objective factors. In other words, ‘principles based regulation’ gives companies more leeway in dealing with its private affairs but it also gives regulators more leeway in judging the actions of a company and as a result it may create unnecessary and unfair legal uncertainty.
However, the problem is not ‘principles based regulation’ in itself which, as explained earlier, has some benefits. The problem is the way this system of regulation is applied by the regulator. On the one side, a gentle and balanced application of a ‘principles based’ system has potential for smarter regulation that helps the markets work more efficiently. On the opposite side, an intensive, intrusive, impulsive and biased application of the principles is very likely to distort the legal system by creating uncertainty about the application of the rules and has potential to produce unjust and abusive results. Unfortunately, the latter is the route the UK FSA is taking.