Rules-based approach vs Principle-based approach to regulation in the Financial Industry

What is the difference between a rules-based and principle-based approach to regulation?

A rules-based approach to regulation prescribe in detail or gives a set of rules, how to behave whereas a principle-based approach to regulation outcomes and principles are set and the controls, measures, procedures on how to achieve that outcome is left for each organisation to determine.

Let me illustrate using a simple example of how driving under the influence of alcohol will be regulated in each dispensation. 

A rules-based approach: “In South Africa, the legal limit for blood alcohol level is 0.05g per 100ml whilst driving”  There is a clear rule on how to behave when drinking and driving. Principle-based approach:  “Please consume alcohol responsibly before driving on public roads.”  The outcome is clear, namely responsible driving on the roads, but the manner in which to achieve this is left open for interpretation.

Implementation of the set of rules within a rules-based approach requires less interpretation and skills.  The Regulator provides rules and an organisation must adopt and implement control measures to ensure compliance with the rules.  Implementation of a set of principles and outcomes requires interpretation and understanding of how an organisation has to conduct itself to meet the outcome and then adopt and implement controls and measures to ensure that the organisation complies will the outcomes and principles.  It is not a “one-size fit all” or “tick-box” manner of implementation and it will differ for each organisation.

Some of the benefits and challenges of a principles-based approach:

Why are we moving away from the rules-based approach to regulation?

During 2011 the Cabinet approved the decision to move to a Twin Peaks model of regulation.  The reform, in the manner how market conduct is regulated, seeks to improve how customers are treated within the financial industry. One of the efforts to ensure that market conduct is improved is to revise the legal framework and that includes the way legislation is written.  Legislation will now include principles and outcomes as law.

In the explanatory memorandum of the Conduct of Financial Institution Bill, published in late 2018, the shift to a principle-based approach is explained as follows: “A narrow focus on rigid rules and compliance reporting has often led to the letter of the law being followed while the spirit of the law is missed. A principles-based approach seeks to set principles that specify the intention of regulation, rather than set rules detailing requirements of a financial institution. A focus on principles should see a shift in both industry and the regulator toward ensuring that their actions and processes are geared toward driving the attainment of certain desired outcomes in the financial sector, not only on technical compliance with the law.”

Does this approach mean there will be no more rules?

No, it seems that the regulator will use a blend of principles and rules to ultimately ensure that market conduct leads to customers being treated fairly.

How will compliance be monitored?

In the current risk-based dispensation, the Regulator monitors compliance with the legislative requirements by requesting the Compliance officer of an Financial Service Provider(FSP) to submit a report made up of questions to confirm whether a rule was implemented and complied with, in a yes or no answer and in some instance to attach an explanation. The Regulator will in the future move away from a report that will simply ask confirmation whether a rule was complied with, and will require FSPs to submit a Conduct of Business report. It is anticipated that the report will focus on the following aspects:

• Business structure, governance and control functions;

• Value proposition( services and customers);

• Promotions, advertising and marketing;

• Client-take on;

• Remuneration;

• Recruitment, training and performance management;

• Complaints;

• Custody of funds and assets and collecting premiums;

• Mandates.

The manner in which the draft report is structured requires the FSP to answer a variety of questions on the aforementioned topic and provide the Regulator with specific information about the FSP.  The answer will give the Regulator insight into the business model of the FSP and how certain processes and aspects are implemented. An FSP will thus be required to elaborate on how certain outcomes have been achieved. There is thus a shift to more intrusive supervision from the Regulator.  

A holistic view of an organisations market conduct risk and how this is addressed through controls, processes and measures will thus be of vital importance.