Arnold Kling  

Principles-Based Regulation

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In my latest essay, I argue for principles-based regulation.


With PBR, legislation would lay out broad but well-defined principles that businesses are expected to follow. Administrative agencies would audit businesses to identify strengths and weaknesses in their systems for applying those principles, and they would punish weaknesses by imposing fines. Finally, the Department of Justice would prosecute corporate leaders who flagrantly violate principles or who are negligent in ensuring compliance with those principles.

In principle, the advantage of traditional rules-based regulation is that the regulated entity knows exactly what is legal and what is not. With principles-based regulation, this is less clear until case law develops.

In fact, I would argue that in financial regulation, precision is a bug rather than a feature. You set up a game in which, I contend,


The bankers are always able to outmaneuver the regulators, staying within the letter of the rules while mocking their spirit.

No regulatory system is perfect. Any regulatory approach is difficult to implement. However, if I were regulatory czar, I would rather work with a principles-based approach than with a rules-based approach for issues like fundamental safety and soundness of insured institutions and basic consumer protection.


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COMMENTS (18 to date)
Foseti writes:

PBR only works in a world without regulatory capture.

It's amazing how many people believe that regulatory capture is a problem AND believe in PBR.

What am I missing?

JeffM writes:

You have missed what is, I think, a common problem with rules-based regulation that would be solved with principles-based regulation.

A rule comes out. It is usually incredibly detailed. It frequently is not as strong as current practice in many institutions because it has been negotiated down in the rule making process by those institutions with poor practices. To comply with the rule, resources are wasted interpreting the rule, redoing forms, programming computers, developing new procedures, and training people. Frequently, it is not worthwhile to maintain a practice that is stronger than what the rule requires because the double expense of maintaining current practice and complying with the rule is prohibitive.

The waste associated with consumer protection rules in banking is mind-boggling. Have you seen the disclosures printed out at account opening? If 1% of the customers read them, I'd be amazed. If 10% of those who read them understand them, I'd be utterly flabbergasted. For example, the rules for check clearing are available from every bank in the US, but most people (in fact most bankers) do not understand them.

Another advantage of principles-based regulation is that Congress can manage to establish principles even though they do not have the expertise to write rules. (Of course it is debatable whether bureaucrats have the expertise to write rules.) But we could dispense with a lot of bureaucrats if they were not writing rules and complying with the APA.

Philo writes:

It is utopian to call for “broad but well-defined principles”; the broader they are, the less well defined they will be. “[I]dentify[ing] strengths and weaknesses in [firms’] systems for applying those principles” requires unrealistically good judgment—almost foresight--by the regulators. Finally, “prosecut[ing] corporate leaders who flagrantly violate principles or who are [flagrantly?] negligent in ensuring compliance with those principles” introduces additional vagueness: what counts as “flagrant”?

In practice, regulation will inevitably be lax in normal times; after a crisis or a notorious debacle it will be tightened. (Almost never will it be loosened; come back, 80’s!) Often this tightening will be done in ways not really relevant to the event, so one cannot even speak of “closing the barn door after the horses have escaped”: often what is closed is the door to some adjacent barn.

Successful regulation is a will-o’-the-wisp. Forget about it!

Norman Pfyster writes:

Of course as a regulator you would prefer PBR: it gives the regulator greater discretion and from an administrative law perspective, that discretion would be very hard to challenge.

The only 'regulation' that will work is incentive based. Eugene White's idea (from the past) of making financial firms' executives post bonds of up to three years salary that can be forfeit if the firm goes under.

Also, not giving shareholders' complete immunity from losses exceeding their investment. Prior to Glass-Steagall they were liable for twice the par value of their investment if they went into receivership.

Or, Phil Gramm's idea from Gramm, Leach, Bliley of having banks hold some of their capital in subordinated debt that couldn't be insured, thus acting as a canary in the coal mine for the bank's safety.

Sieben writes:

Inb4 a janitor sues Exxon for not treating him with "Human Dignity".

JeffM writes:

@ Mr. Physter

Given the deference accorded by courts to the regulating agency to interpret its rules and its own authorizing statute, the agency's ability to translate "guidelines" that have never been through the APA process into what are regulations in practice, and given the inherently subjective nature of the examination process itself, the supposed greater constraint imposed upon an agency by a rules-based regulatory regime is purely illusory.

As for the other comments calling for punitive measures to be taken against the shareholders and management of banks that get into trouble, banks are in the business of taking risks. Providing liquidity means being illiquid yourself. If the object is to restrain banks that are too big to fail, the solution is to break them up promptly after they are so identified. As for banks that are not too big to fail, the ability of the regulators to impose civil money penalties through their own administrative tribunals (penalties that are not permitted to be paid out of D&O coverage) and the prohibitions on golden parachutes for management of troubled banks already places the management of banks under more stringent penalties for failure than are borne by the managers of other companies that fail.

raja_r writes:

Patrick beat me to it.

I work in computer security and deal with regulations (govt or industry standards) all the time. In this field, neither rule-based nor principle-based standards work.

Rule based standards often are not applicable or actually harm networks by introducing unnecessary complications.

Principle-based standards don't work because then you are at the mercy of the auditor. If the auditor does not understand how something works, then you are SOL.

The only regulation required is the good-old "if you fail, you pay the price".


This old Atlanta Fed paper has a good discussion of the subordinated debt issue. Having been written before 2008, means it isn't 20/20 hindsight;

-Sub-debt prices and other information should be used in monitoring the financial condition of the 25 largest banks and bank holding companies in the U.S.40

Procedures should be implemented for acquiring the best possible pricing data on a frequent basis for these institutions, with supplementary data being collected for other issuing banks and bank holding companies.

Supervisory staff could gain experience in evaluating how bank soundness relates to debt prices, spreads, etc., and how changes in these elements correlate with firm soundness.

-Simultaneously, in line with the mandate of the Gramm-Leach-Bliley Act, staffs of regulatory agencies should study the value of information derived from debt prices and quantities in determining bank soundness, and evaluate the usefulness of sub-debt in increasing market discipline in banking. Efforts should be made to obtain information on the depth and liquidity of debt issues, including the issues of smaller firms.

-If deemed necessary, the regulatory agencies should obtain the necessary authority (via congressional action or regulatory mandate) to allow the federal banking agencies to require banks and bank holding companies to issue a minimum amount of sub-debt with prescribed characteristics, and to use the debt levels and prices in implementing prompt corrective action as
described in FDICIA. The legislation would explicitly prohibit the FDIC from absorbing losses
for sub-debt-holders, thus excluding sub-debt from the systemic risk exception in FDICIA.

-The bank regulatory agencies should work to alter the Basel Accord to eliminate the unfavorable characteristics of sub-debt: the 50 percent of Tier 1 limitation and the required
amortization.

Anonzmous writes:

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Pietro Poggi-Corradini writes:

What would the incentives of the regulator be that would keep his/her zeal in check. Are you writing a blank check for discretion run amok?

Joe Cushing writes:

Sounds like a recipe for rule of man instead of rule of law. The amount of POWER the people in government would have to make up the rules as they went along would make the system completely corrupt. Each regulator would be king of that area of regulation. Somewhere out there, there would be a king of steel, a king of cars, a king of banking. Such a king would have the power to determine who could be in business and who could not.

Matt C writes:

> However, if I were regulatory czar, I would rather work with a principles-based approach

Well, sure, if you are Czar or Kaiser or whatever, you want as much power as possible, with as few constraints as possible. But since you probably won't be that person, do you really want George Bush III's latest crony to have those powers over you?

Why do you imagine these broad and discretionary powers will be used for good instead of evil?

Jonathon Hunt writes:

Aren't the businesses punished for their weaknesses everyday in the market already? I mean, I recall there being both profit AND loss.

Roger Sweeny writes:

This sort of exists already. Most all of America's antitrust laws can be typed out in less than ten pages. They purport to set out principles.

However, there are now millions of pages of court decisions in antitrust cases, and hundreds of thousands of pages of law review articles and treatises trying to explain exactly what you can and cannot do.

Erroll writes:

Are you arguing for principles-based over rules-based regulation in general or just for banking? Why?

You say that a disadvantage is less certainty about what is legal, but only "until case law develops." Would it be fair to think of this case law as rules-based regulation written by judges? Why not?

zgatt writes:

What governments seem to have moved away from in our times is a hierarchy of specification of law. That is, principles laid out succinctly with attention to capturing the spirit at some top level, that is successively refined and explicated in 'lower' levels of law and regulation.
I agree that things have to be explicated eventually in order to have some concept of 'rule of law': fairness, universality, resistance to local/regional corruption. But the idea that it all has to be laid out in one single attempt at complete micromanagement seems to be a problem going around.
Is this the original principle of US law?

Evan Soltas writes:

I wrote a response to your article on my blog here:

http://esoltas.blogspot.com/2012/05/principled-regulator.html

While I have a visceral like for the idea of principles-based regulation, I fear that the details don't work very well:

"My problems with principles-based regulation are that could establish due process rights where it may be more effective to draw bright lines, that it could create considerable regulatory and political uncertainty, that it would make markets less efficient due to imperfect information, and that trying to establish principles goes far beyond minimalist 'rules of the road.' "

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