What’s the best way to set rules for the financial industry?

The regulation of the global financial system has dominated industry news for almost a decade since the subprime mortgage lending crisis. From early 1990s onward, the theme was deregulation and globalization of the financial system for growth and prosperity. This is a cycle that seems to be revisited on a regular basis for the past century and a half.

In the aftermath of the referendum on the exit of the United Kingdom from the European Union and the recent presidential election in the United States, it is now just as probable at least some regulations may be repealed as it is new ones may be introduced.

If we pass beyond the usual ideological rhetoric questioning the necessity, costs and intrusiveness of regulations, we would have to agree that there is a consensus that the industry will be regulated. Arguably, the past regulations may not have served us well, and may have not been enforced with requisite diligence or competence.

Consequently, any further policy debates are likely to focus on what type of regulations and which supervisory models will lead to better stability, liquidity and effective management of risks in global markets.

So what are the options and how to implement them and when?

Historically, national governments and international agencies have relied on two models for supervision of the financial system: the rules-based approach, also known as the “bright line” approach, and the principles-based approach. A third option that has been a point of discussion in the aftermath of almost every crisis since the South Sea Bubble in the 18th century, which is supervision through structural measures and reforms.

Bright line regulations focus on specific procedures and define rules. The rule define what is allowed and draw the line between compliance and non-compliance. One example of a this approach would be the requirement for securities trades to settle within three days of execution, also known as T+3 settlement. Another example would be mark-to-market rules for traded assets. The Sarbanes-Oxley Act and Dodd-Frank Act are also examples of legislation based on the bright line model.

The principles-based approach focuses on broader guidelines that firms are expected to follow. It monitors compliance on the basis of outcomes. Based on well-defined principles, the regulatory agencies audit processes and systems for gaps, vulnerabilities or ineffectiveness, and if violations of the principles are observed, penalties would be imposed. The management is accountable for failure to produce the prescribed outcomes under this approach.

In order to protect consumers in home equity loan applications, the governing principle would be to disclose potential costs of having interest rates and home valuations change in the next five years. The requisite outcome is an educated customer before the loan is approved. If loans are approved without adequate disclosure, an enforcement action would result under the principles-based model. The institutions would be free to develop their own internal processes, applications and systems, and decide how to produce the outcome.

These processes would be subject to review and audit by the governing entity and internal audit committees. The Basel Committee on Banking Supervision’s second and third initiatives, known as Basel II and Basel III, are the well regarded examples of the principles-based model. Most recently, the Fundamental Review of the Trading Book (FRTB) is the latest Basel principles-based supervision aimed at global compliance.

The bright-line model is far more specific in terms of procedural detail. The rules may be complied with and not necessarily affect outcomes favorably. In fact, it is difficult to imagine how the outcomes would be used as a metric in compliance enforcement when it can be demonstrated that rules have been followed.

With the principles-based model, there is room for interpretation as to the degree of effectiveness of internal processes in securing outcomes relative to extraneous factors. Also, the principles may be too broad to serve as a guideline to design internal processes and enforce uniformly.

Academics and legal experts also point out that there is too much latitude allowed to management under the principles-based model. In spite of this, it is reasonable to argue that principles-based models with management accountability are likely to be more effective in enhancing both stability and consumer protection in financial markets.

{mosads}The experience so far with bright-line model is that it is costly, time consuming and disruptive. Critics also claim that proper enforcement presumes that regulators have the expertise and experience available, and this has not been the case, given the cost of retention of requisite skill sets.

On the other hand, it is hardly noted that both the industry and litigators are more comfortable, both conceptually and culturally, with complex rules because they seem to be easier to adjudicate, to lobby legislators and to negotiate with regulators on enforcement guidelines.

The European Union progresses with regulations that increasingly lean in favor of principles-based models. Examples include the Markets in Financial Instruments Directive (MiFid) and European Market Infrastructure Regulation (EMIR).

The United States, with a historical legacy of bright-line models, is facing uncertainty in light of a new administration taking office. It is difficult to make predictions about the policies that shape the global financial system. It is possible to see the third option, structural reform, emerge as a platform for consensus, as it might be favored by central banks, the International Monetary Fund and the World Bank.

A well known, indeed celebrated example of regulatory supervision through structural design, is the Glass-Steagall Act that was in effect until 1997. Establishing boundaries by line of business and limiting concentration in those businesses, thus indirectly fostering local competition, worked in terms of both stability and consumer protection. The Bretton Woods system would be another example on a global scale.

These three models, whatever combination they are adopted across regions, will shape the agenda in the G20 meeting in Germany this year, as well as the discourse between regulators and central banks, politicians and business leaders. Although consensus and resolution may not be possible soon and the trend may be in favor of principle-based models, the debate will continue to be intense and arduous.

Sinan Baskan is a solutions director for financial services at MarkLogic. He previously served as head of global capital markets at SAP, head of risk information technology at HSBC Bank, and director in the risk analytics practice at KPMG.

The views of Contributors are their own and are not the views of The Hill.