The Rules Of Practical Principles

By Michael Mainelli
Published by Journal of Risk Finance, The Michael Mainelli Column, Volume 8, Number 5, Emerald Group Publishing Limited, pages 508-510.

Rules or Principles?

In the lunchrooms and boardrooms of the Square Mile that I have the privilege to visit, the topics are wide and varied. Consumer debt, housing market bubbles, competition among exchanges and brokers, third world opportunities, climate change, treating customers fairly, the alchemy of investment returns, risk management, dangers lurking in CDOs … Yet all conversations turn to the burden of regulation. The conversations are not all negative. Firstly, my conversational partners note that London may have gained from USA regulatory ineptitude on Sarbanes-Oxley, as it did from Eurodollar problems in the 1960’s or Glass-Steagall in the 1980’s. Secondly, somewhat smugly, discussants note that compliance and regulation are barriers to entry. Name a major new entrant in the past few years? But ultimately, the one phrase that guaranteed to get all heads wagging in agreement is that “London’s principal advantage is principles-based regulation, as opposed to the USA’s rule-based regulation”. Well, that sums it up then.

Not quite. The phrase ‘light touch’ is often used to describe the UK’s principles-based regulation, but even Sir Callum McCarthy, Chairman of the Financial Services Authority (FSA), is quick to question whether a rule book exceeding 8,000 pages is truly ‘light’. Sure, miscreants can be fined for violating FSA’s 11 Principles, as opposed to the roulette of the USA legal system for a regulator who knows a principle’s been broken, but doesn’t have the requisite legislative tidiness to enforce. But the FSA has enough complexity. It’s a bit like European or American debates on corruption – “I grant you we have problems, but look at Nigeria”. That’s not an answer at all. The truth is no social system is perfect and all can use improvement. Thus, it was with some anticipation that I attended the launch of the Centre for the Study of Financial Innovation’s report of their Working Group on Effective Regulation, “Principles in Practice: An Antidote to Regulatory Prescription” [CSFI, 94 pages, 2007, ISBN 978-0-9551811-2-2]. I think it’s a great contribution and worth reading for a broad grasp of complex issues.

The report covers the objectives and formulation of regulation, working through some of the problems with implementation and enforcement. In the report, Andrew Hilton OBE sets out the downside of regulation, starting with “all regulation is bad”. He makes some serious points that, despite its apparent necessity, regulation is not a free good, difficult to cost, has no natural enemy, favours the big, provides barriers to entry, inhibits innovation, hurts consumers and “has a tendency to migrate”, i.e. regulatory creep. A ‘slam dunk’ you might think. But the report’s milquetoast conclusions are the usual platitudes, “formal regulation should be a last resort”, “benefits should outweigh the disadvantages” or “market participants should be embedded in the regulatory process”.

In summary, the report runs the sensible-regulation ball 99 yards down the field very well, but fails to score for me. I think the journalistic “top line”, “bottom line”, “where’s the beef?” questions have a point in this case, much as it galls me to admit it (particularly as I’m known to point out that the world is, sometimes, just complicated). Why am I so dissatisfied? Perhaps the time has come to realise that any long-running, simplistic, two-sided debate, such as “more regulation” versus “less regulation”, is unlikely to find resolution. Further, unless the wider financial services community can articulate an alternative vision to more or less regulation, few outsiders can understand what we’re whinging about.

Financial services professionals need to show that there is an alternative, a third way, that can come before regulation yet control unfettered markets. I think we need to consider, design, and loudly promote “standards markets” as a substitute for many regulatory initiatives. We can use “standards markets”, “kitemarks”, “accreditation & certification” in existing and future regulatory areas such as anti-money laundering (an audited compliance), treating customers fairly (a kitemark) or MiFID best execution (an audit against a management standard, similar to ISO 9000). These standards markets keep global shipping, aviation, electrical, chemical, pharmaceutical and other complex industries with the potential to harm consumers, on their toes. Why not us?

Many of the current examples of enlightened regulation, such as moves to IFRS, are a return to the idea of self-regulation, but self-regulation with teeth, in a competitive market for certification, with open standards. Before tinkering with “better” regulation, we should wonder if we can create international, open, standard zones that allow mutual international recognition before tinkering with “better” regulation. These international markets handle flight risks, fire risks, electrical risks and poisoning risks, why not financial risk?

Standards or Markets – Why Not Both?

“Regulators exist to regulate; compliance officers exist to comply”. So there are a lot of vested interests and it’s a long slog to sell material change to the status quo, but I’d make some quick points: (1) the current international regulatory system is a mess and in conflict with interfering national regulatory systems; (2) standard markets are just a return to the history of finance, e.g. accounting being a 19th standard market response to getting ripped off; (3) many of our current examples that we laud, e.g. IFRS, conform to this model; (4) it’s how the big bad world of planes, trains, automobiles, electricity, quality, etc all manage themselves rather well, e.g. ISO, CCITT; (5) standards markets are rather SRO-like, but SRO with teeth and money; (6) the software Zeitgeist of “open standards” fits financial services rather well too. If anything, the financial markets are hypocritical to suggest that the standard market approach does not apply to them. But do note the key principles:

  • open standards must be available to all;
  • development of the standard is an open, structured, inclusive process involving interested stakeholders, conflicts of interest are eliminated and comparators available;
  • certification agencies compete for audit business – thus encouraging rational interpretation(s) of the standard and controlling cost and quality via reputational risk and competition, and the system can prove exclusion, e.g. certifiers actually mark down organisations that fail to meet the standard;
  • outputs such as certifications and grades awarded are published; ideally some benchmarking on the degree of pass or fail is given to participants;
  • ideally the certifier bears some indemnity and that indemnity can, with the price paid by the buyer, be made publicly available;
  • there is an authorised, responsible accrediting body for certification agencies that helps to ensure proportionality and consistency; accreditors ensure the separation of standards development from the commercial elements of implementation and review; accreditors regulate the market of standards certifiers;
  • accreditors can sanction certifiers, for instance ensuring that certification is separate from improvement, e.g. there are no conflicts of interest where firms sell consultancy services to attain a standard alongside certification services;
  • accreditation bodies are independent from commercial conformity assessment activities and, unless the system is seriously flawed, accreditation is probably best left to a sole entity, i.e. non-competitive.

The financial services regulatory debate needs a new bottom line and I think it’s a return to:

  1. do we need anything other than a free market?
  2. if we do, can we use a standards market?
  3. if we can’t, can we structure appropriate regulation?

Many societal goals for markets can be achieved with innovative, quasi-regulation that bridges the market-government gap using markets themselves, i.e. standards markets. Financial services needs to realise that standards markets offer a way out of Screaming Lord Sutch’s conundrum, “Why is there only one Monopolies Commission?” Our key Principle should be that, before we start regulating, we try and let standards markets make the Rules.

Professor Michael Mainelli, PhD FCCA FSI, originally undertook aerospace and computing research, followed by seven years as a partner in a large international accountancy practice before a spell as Corporate Development Director of Europe’s largest R&D organisation, the UK’s Defence Evaluation and Research Agency, and becoming a director of Z/Yen ( Michael is Mercers’ School Memorial Professor of Commerce at Gresham College (

Z/Yen operates as a commercial think-tank that asks, solves and acts on strategy, finance, systems, marketing and intelligence projects in a wide variety of fields (, such as developing an award-winning risk/reward prediction engine, helping a global charity win a good governance award or benchmarking transaction costs across global investment banks. Z/Yen’s humorous risk/reward management novel, Clean Business Cuisine: Now and Z/Yen, was published in 2000; it was a Sunday Times Book of the Week; Accountancy Age described it as “surprisingly funny considering it is written by a couple of accountants”.

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[An edited version of this article first appeared as "The Rules of Practical Principles", Journal of Risk Finance, The Michael Mainelli Column, Volume 8, Number 5, Emerald Group Publishing Limited (October 2007) pages 508-510.]