It’s About Soccer, Not Football

Chalking this up to weird timing, but Treasury Secretary Paulson announced plans a few weeks ago to fix the financial markets. It would take a long time to legislate and would not likely be completed before President Bush finishes up his term. What the housing market really needed back then, was leadership on solutions covering the immediate problems such as the lack of credit availability or liquidity and a US economy teetering towards a recession.

In James Surowiecki’s excellent Parsing Paulson piece in the New Yorker, he notes:

As the press has noted, the plan would consolidate our myriad and overlapping regulators into fewer, bigger ones. But the most interesting thing about it is something subtler: a push to move from our current system of regulation—often known as “rules-based”—toward a “principles-based” approach. In a rules-based system, lawmakers and regulators try to prescribe in great detail exactly what companies must and must not do to meet their obligations to shareholders and clients. In principles-based systems, which are more common in the U.K. and elsewhere in Europe, regulators worry less about dotted “i”s and crossed “t”s, and instead evaluate companies’ behavior according to broad principles; the U.K.’s Financial Services Authority has eleven such principles, which are often deliberately vague (“A firm must observe proper standards of market conduct”). This approach gives companies more leeway in dealing with investors and customers—not every company needs to follow the same rules on, say, financial reporting—but it also gives regulators more leeway in judging whether a company is really acting in the best interests of shareholders and consumers.

Football (Rules-based)
In a rules-based environment like Wall Street has now, there a lot of rules that the financial institutions must follow and the regulators enforce the rules. Football, like most American sports, is heavily rule-bound. There’s an elaborate rulebook that sharply limits what players can and can’t do (down to where they have to stand on the field), and its dictates are followed with great care.

Soccer (Principles-based)
The regulators have more authority to interpret and pass judgement on the activities of Wall Street. Soccer is a more principles-based game. There are fewer rules, and the referee is given far more authority than officials in most American sports to interpret them and to shape game play and outcomes. For instance, a soccer referee keeps the game time, and at game’s end has the discretion to add as many or as few minutes of extra time as he deems necessary. There’s also less obsession with precision—players making a free kick or throw-in don’t have to pinpoint exactly where it should be taken from. As long as it’s in the general vicinity of the right spot, it’s O.K.

Not surprisingly, Wall Street favors the principles-based approach rather than rules based (it’s likely to be less complex and less onerous to comply with). Paulson is an ex-Wall Streeter.

In Newsweek, one of Henry Paulson’s top Treasury Department aides spoke on how United States and world policymakers are responding to the fallout of the global credit crunch.

The short answer is that we are in the midst of a phenomenon painfully familiar to Americans. From the gold rush to the Internet bubble, cycles of innovation, excess, adaptation and recovery to a point of even greater prosperity have defined America’s economic progress. In the present situation, we are seeing the rough edges of the same recent financial innovation that has brought enormous benefits to many investors, businesses and consumers. But these net benefits are of little consolation to the Americans whose lives are being seriously disrupted by the current financial-market turmoil. In response, policymakers in the United States and around the world are taking aggressive and targeted actions to stabilize financial markets, reduce the impact of markets on the U.S. economy and protect against the same mistakes’ being repeated.

blah, blah, blah

But now, focus is shifting to correcting the problems on Wall Street with the adaptation of successful new financial products. Thats where the new solutions to the credit crisis will get interesting.

As the immediate remedies take effect, we have also begun to focus on the weaknesses in business practices of financial institutions that this experience has revealed, and on fragmented U.S. and European regulatory structures that had difficulties guarding against or responding to modern challenges. U.S. and international policymakers are acting in a targeted but comprehensive way to address the causes of current market instability with steps including strengthening the oversight of risk management and reporting practices of global financial institutions; enhancing disclosure of and the process for setting values for complex products; changing and clarifying the role and use of credit ratings; strengthening the process by which national authorities monitor and respond to risk, and reforming the mortgage-origination process. In each of these broad categories, the specific proposals are concrete, widely accepted and, in a number of cases, already being implemented by national or international authorities as well as by the private sector.

Charting the source: Where news happens… or, more accurately, where news is reported from [Reuters]

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5 Responses to “Paulson Proposes Principles-based Instead Of Rules-based Approach”

  1. Jon says:

    Are you implying that a principal based system is somehow more lax than a rules based system? If so, you are mistaken. I have worked in the UK financial markets and the US financial markets. Take as an example Enron. No rules were necessarily broken when they financed off-balance sheet. But it would never have passed a principal-based test since the purpose behind it violated all sorts of principals. Principal based systems are much simplier and without exceptions. Put another way, rules systems are form over function, principals systems are function over form. Wall Street would much rather have rules — they can be circumnavigated much easier than principals.

  2. Interesting. But why is Paulson, a former Wall Streeter, advocating principal based?

    Nah, I am not advocating either. I think the problem between both is the the principal based system only works if the regulators have a lot more power than they do now and I am not sure they are up to it or we are ready to trust them with that power.

  3. Instead of one or the other, how about a balance between rules and principles?

    What the regulators simply do not have enough of is MONEY to regulate their own rules.

    If the industry does not want to self-regulate then the industry should plan for increasing the fees they pay government to pay for more regulation.

  4. Jon says:

    I think Paulson knows the power of a principal based system (vs rules). Just because he came from Wall Street doesn’t mean he is a snake or Wall Street’s lobbyist. Lots of regulators came from the Street and weren’t thought of as there to run interference for their buddies. For example, Arthur Levitt ran the predecessor of Lehman. And Joe Kennedy…A hybrid system won’t work and will be manipulated to create loopholes. Principals are much more powerful.

  5. Interesting – It seems to me that principle-based will only work if the regulators have near-autonomy. I would think that the problem with rules-based regulations as we have now is that both sides have to expend a lot of resources to follow the regs and the regulators don’t have the same depth of resources that the private sector does – a lot of loopholes in the current system I suspect, which is why Paulson is probably trying to overhaul the whole thing. Damn this is abstract!