Why We Need Principles-Based Regulation

May 29, 2012

When we think of regulation, we think of specific rules that spell out the boundaries of what is approved and what is forbidden.  For example, requiring credit card issuers to give 45 days' notice prior to a rate increase.  This is best classified as bright-line regulations (BLRs).  BLRs have the tendency to plug individual holes in a boat, hoping it will stay afloat, says Arnold Kling, a member of the Financial Markets Working Group at the Mercatus Center of George Mason University.

A more efficient and effective system of protection would rely upon principles-based regulations (PBRs).  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.

Under such a system, one of the primary impacts would be greater responsibility among corporate executives.

  • Under the current system, when executives engage in wrongful behavior by violating BLRs, they often go unpunished by placing blame on individual employees.
  • PBRs, however, by broadly applying the spirit of the law, would allow for greater flexibility in seeking out wrongdoers.
  • This would encourage executives to take greater care for the actions of their employees and ensure that their business operated ethically.

Furthermore, under this system, the role of regulators would not be nearly as invasive as it is under the status quo.

  • Under PBR, the primary tool of regulation would be random management audits conducted by the regulatory agency.
  • The audit would grade the company's systems for aligning its actions to the various principles, and audit grades would be made public.
  • Regulators would also be sure to make clear the meaning of principles, avoiding overgeneralization and instead focusing on providing clear means of compliance.

The fundamental flaw in BLRs is that they pit regulators against market actors, to the benefit of the latter.  Bankers, for example, have regularly proven their adeptness at outmaneuvering regulations, keeping to the letter of the law while mocking its spirit.  PBRs would do much to address this issue.

Source: Arnold Kling, "Why We Need Principles-Based Regulation," The American, May 22, 2012.

For text:

http://www.american.com/archive/2012/may/why-we-need-principles-based-regulation

 

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