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Home > Regulation Best Practice > Principles versus Rules in Financial Supervision—Is There One Superior Approach?

Regulation Best Practice

Principles versus Rules in Financial Supervision—Is There One Superior Approach?

by Marc Quintyn

Executive Summary

  • Financial liberalization, which started in the 1970s, has altered the nature of financial operations dramatically. In contrast with the pre-1970s, often called the period of financial repression, good financial institution governance is now critical for the soundness of the individual financial institution, and, by extension, the stability of a country’s financial system.

  • In response to these deep and far-reaching changes in the financial sector, financial regulation and supervision has become much more important than ever before, and the nature of its business has been changing in equally dramatic ways.

  • Supervisors were likened for the longest time to compliance, or box-ticking officers. Now, in this governance-driven financial environment, they have become “governance supervisors,” monitoring the operations of the financial institutions on behalf of the diffused and ill-informed deposit-holders of these institutions.

  • Since the start of this transformation of the supervisory approaches, debates have been conducted about the optimal way to supervise the financial systems. Some jurisdictions believe in a principles-based approach, while others swear by a rules-based approach.

  • The discussion is about guiding, or keeping in check, financial institutions through broad-based principles versus well-defined, specific rules. Practice shows that life is too complex for any of these two extremes alone. Both systems have their pros and cons, and best practice seems to go in the direction of a supervisory approach that offers a balance of principles, supported by guidelines and rules. In the aftermath of a crisis, all sides call for more rules; in quiet times, all sides think that they can steer the course with principles. As normal times inherently carry the seeds of a crisis within them, any supervisory system should balance rules and principles.

Introduction

The Challenging Nature of Financial Supervision

Two things can be stated with certainty about financial sector supervision. First, that few professions have changed so dramatically in recent years, in form, approach, scope, and substance. Second, that the task of supervisors, when compared to several other domains of public policy, has become extremely complex, and that no end is in sight with regard to this process. These fundamental changes are taking place in response to the equally dramatic changes that we are witnessing in the sectors they are mandated to oversee.

Financial Liberalization

It all started with financial liberalization, which took hold in the 1970s. Between World War II and the 1970s, all financial systems around the globe were heavily regulated, or mainly in government hands. It had become common to describe the government’s approach to handling the system as “financial repression.” From the mid-1970s on, first domestically, and subsequently internationally, liberalization triggered many changes that profoundly altered the face of the financial system and the nature of its operations. Financial liberalization, in turn, unleashed competitive forces, first within the banking systems, subsequently within other subsectors, and finally among all of them, leading to a blurring of boundaries among previously clearly delineated subsectors, such as banking, securities markets, and insurance. Fierce competition pressurized financial institutions to take on more risks to outpace competitors and ensure lasting profitability. Major advances in information and communication technologies further propelled this process forward—provisionally, until a few years ago when the system collapsed under the weight of too many incorrectly assessed risks and too much leverage.

Adequate risk management requires high-quality governance of financial institutions in order to preserve financial sector stability in this new environment. In sharp contrast with the financial repression period—when financial sector behavior was largely prescribed, and financial institution governance, therefore, was left with only a few degrees of freedom—financial institution governance has become a crucial variable in guaranteeing the success of these liberalized and globalized financial systems.

Reorientation of Financial Supervisors’ Work

Such dramatic changes in the way the financial sector operates have required major adjustments in the supervisor’s regulatory and supervisory frameworks, and in the ways they enter into dialogue with the supervised entities.2 Thus, supervisors had to metamorphose from compliance, or box-ticking, officers in the old, repressed systems, to what we would call now “governance” supervisors. They needed to replace their reactive approach with forward-looking, proactive ways of doing business with financial institutions. Under this new paradigm, the task of the supervisor is mainly to monitor and guide financial institutions to implement comprehensive risk management and internal control frameworks suitable for their particular institutional risk profiles, subject to prudential standards.

This view of regulation and supervision is closely aligned with Dewatripont and Tirole’s (1994) “representation hypothesis” of regulation. Prudential regulation “...is primarily motivated by the need to represent the small depositors and to bring about an appropriate corporate governance for banks” (p.35). Managers of financial institutions have a fiduciary responsibility towards their shareholders, but the feature that distinguishes financial institutions from the rest of the corporate sector in the economy is that they also have a very large and diffuse group of stakeholders (or debt-holders), many of them not well-informed about their financial institution. So, the above view sees the supervisor as performing the role of one important stakeholder in the financial institutions’ corporate governance, representing the set of diffuse stakeholders, i.e., the depositors. From this follows that bank regulation and supervision have become part of the overall corporate governance regime of financial institutions.

In such a framework, financial institution governance consists of two parts: The regulators ensure debt governance, and shareholders ensure equity governance. As a result, bank managers have to serve two masters, the shareholders and the regulators, the latter representing the bulk of the uninformed stakeholders. These governance arrangements thus induce, or force, management to internalize the welfare of all stakeholders, not just shareholders. In recent years, this role has gained even more prominence because financial liberalization has also led to a “privatization of risk,” whereby savers are increasingly dependent on financial markets to determine their future financial security. This development requires more attention from the supervisors to risks that customers take upon themselves when confronted with an opaque financial system.

An Ongoing Process

So, there is broad agreement on the rationale—financial regulation and supervision are needed—and on the objectives—soundness of the individual institutions to preserve financial sector stability. But how about the best approach to get from starting point to objective? This is where most of the debate has taken place in recent years, and is most likely to continue for several years, as the discussions in the aftermath of the 2007–2008 financial crisis are amply demonstrating. As the debate about the best supervisory approaches continues, discussions are frequently presented in the form of dichotomies such as “principles-based versus rules-based supervision.”

This debate is about the best approach for ongoing, day-to-day supervision of financial institutions. Typically, “either/or” discussions attract a lot of attention and often have a tendency to misrepresent the extreme concepts. We will therefore present the origins of the debate, clarify the concepts and review their merits, and see how close or how far we are from best practices in financial supervision.

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Further reading

Books:

  • Dewatripont, Mathias, and Jean Tirole. The Prudential Regulation of Banks. Cambridge, MA: MIT Press, 1994.
  • Norton, Joseph. “Selective bank and environmental developments: Supervisory trends upon entering the twenty-first century.” In International Monetary Fund (eds). Current Developments in Monetary and Financial Law. Washington, DC: IMF, 2003.

Articles:

  • Geneva Reports on the World Economy. “The fundamental principles of financial regulation.” Preliminary conference draft, 2009.
  • Gould, Ronald. “Financial regulation—Flattering misconceptions.” Conference presentation, AEI, March 29, 2007. Online at: www.aei.org/event1483
  • Kydland, Finn, and E. Prescott. “Rules rather than discretion: The inconsistency of optimal plans.” Journal of Political Economy 85:3 (1977): 473–491.
  • Quintyn, Marc. “Governance of financial supervisors and its effects—A stocktaking exercise.” SUERF Studies, 2007/4.
  • Schwarcz, Steven. “The ‘principles’ paradox.” Duke Law School Legal Studies, Research Paper No. 205, March 2008.
  • Wallison, Peter. “Fad or reform: Can principles-based regulation work in the United States?” AEI for Public Policy Research, June 2007.

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