Principles-based oversight...are we ready?

If one has attended industry conferences over the last 12 months, words such as Twin Peaks and Principles-based oversight would in all likelihood have been included in one of the speeches.

We should understand that these terms and phrases relate to a potentially seismic shift in the way that financial authorities regulate the conduct of industry participants. Regulatory authorities are seeking to achieve a more efficient model as the recent financial collapses in the US and Eurozone revealed that the regulatory authorities were in many instances caught horribly unprepared for the scale and consequences of what transpired.

The traditional rules-based approach had largely failed and associated risk control systems and procedures from both regulators and industry players were likewise found to be wanting. Clearly new thinking was required.

One of the consequential benefits of disaster is the need for post mortems and new thinking. A beneficiary of this new thinking has been the rise and rise of so-called principles-based oversight. This model takes us away from the traditional rules-based approach where one would typically look at a piece of legislation, dissect it into a compliance risk management plan, and effectively tick where the firm was affected by regulation, and ensure that the correct boxes were ticked; in effect giving a theoretical 100% compliance score.

The weakness of the rules-based system is that you will always have individuals who seek to circumvent rules which they perceive as being problematic or getting in the way of business.

The principles-based regime places greater onus on the firm to demonstrate what steps they have taken to comply with high level principles rather than a plethora of rules.

If we look at the Treating Customers Fairly (TCF) initiative, this is perhaps the first instance of a material regulatory initiative which has a large component of principles entrenched within it. Specifically, of course, the principles of fairness and fair treatment of customers and counter parties. Fairness is, of course, a largely subjective concept and different individuals will have different interpretations of what constitutes fairness based on their own business culture and ethics.

For exactly this reason, it is extremely difficult to build an effective “rules only” oversight regime. TCF lends itself far more easily to principles based oversight. This, in effect, requires a firm to demonstrate how they have applied principles of fairness within their business and to be able to evidence this to the Regulator or other authorities as may be required.

Of course, the principles concept is more difficult than the rules concept for both the Regulator and for the compliance community, as it removes the certain grid that can be associated with rules, and replaces it with a far more opaque and intrinsic requirement.

Indeed it will be a challenge for both the Regulator and compliance officers who have worked with rules for the majority of their careers now to suddenly switch over to a principles-based regime.

I certainly foresee training required for both regulatory personnel and compliance officers if the principles-based compliance and oversight is to be a success in the future.

Typically only mature compliance environments are able to sustain a principles-only based environment and I do not foresee this as being a viable model in our jurisdiction at this point in time. It is far more likely that a blend of principles and rules will exist as there will unfortunately always be those who require rules and the big stick before they will do anything.

I personally look forward to seeing more principles-based oversight as it is a more intelligent and effective way of complying with legislation, although, make no mistake, there will be plenty of hard work for all concerned.