In a rules-based systems, the regulator writes the “rulebook” and FSPs comply, whereas in the principles-based systems, FSPs are more involved with regulation in the sense they need to document how their decisions are consistent with the outcomes of regulation. This article explains the fundamentals of principles-based market conduct legislation. The opportunities, benefits and risks of principles-based legislation will be highlighted in future articles.
During a compliance presentation hosted by Compli-Serve in August 2022, Hannelie Hattingh, Senior Specialist Market Conduct Strategy at the Financial Sector Conduct Authority (FSCA) made the following remarks regarding the Conduct of Financial Institutions (COFI) Bill:
“The main aim of the COFI Bill is to introduce the holistic conduct framework for financial institutions, and the intention is that it will apply across all the sectors that we regulate.” According to Hattingh, the emerging regulatory framework encompasses both principles and rules. “There will be a balance between principles and rules,” she explained. “In some instances, rules will be appropriate for a specific market or element that we are regulating but the main aim is for an outcomes- and principles-based approach.”
Source: FAnews (Gareth Stokes)
COFI will therefore be more principles-based market conduct legislation as opposed to FAIS, which is regarded as more rules-based. To be honest, when principles-based and rules-based legislation were first highlighted almost 10 years ago, I had no idea what the real difference was, and I had to do some serious homework on the topics to avoid further embarrassment. I quickly realised that behind all the principles and/or rules, complex reasoning will have to occur before one can truly start making sense of it, and then the complexity needs to be simplified for the benefit of all. This article aims to provide you with a better high-level and simplified understanding of the difference between rules-based and principles-based legislation, starting with a focus on the latter.
It is always helpful to begin a topic by defining it properly, and once again the Oxford Business English Dictionary offers great assistance as it describes a principle as a law, rule, or theory that something is based on or a general or scientific law that explains how something works or why it happens.
Essentially, principles-based regulation means moving away from reliance on detailed, prescriptive rules and relying more on high-level, broadly stated principles that set the standards by which FSPs must conduct their business. So, practically, the FSCA, instead of prescribing the actions that FSPs must take, would take a step back and define the outcomes that they require providers to achieve. FSPs and their management will then be free to find the most efficient way of achieving the outcome required. The logic of this strategy is based on the idea that FSPs and their management are better positioned than regulators to determine what policies, processes and actions are required within their businesses to achieve a given regulatory objective.
I firmly believe that volumes of legislation, which is the case with COFI that must be read with the Financial Sector Regulation Act, does not necessarily guarantee regulatory quality or government effectiveness. Intuitive reasoning often leads us to assume a higher importance to legislation that is voluminous, more specific, and with detailed rules that could determine a solution for each problem, but we also know that in practice this is not possible. The quantity of legislation even produces the exact opposite effect and often brings complexity and confusion. In this sense, principled-based legislation is good, because it will offer more flexibility for FSPs to be innovative and simplify compliance within the COFI framework.
Principles-based regulation is a regulatory strategy that allows FSPs to determine how to meet regulatory demands. According to the authors of ‘Principled-based regulation-better regulation’, principles-based regulations are outcome focused regulations that concentrate on the goals and objectives of regulations rather than their processes. Conceptually, principles-based standards are more reliant upon professional judgment of FSP management, and they move away from detailed, prescriptive rules and supervisory actions that instruct FSPs how to manage and operate their business.
Characteristics of principle-based regulations
Principles have a number of characteristics, which include but are not limited to the following:
– They are drafted in generic terms that contain overarching requirements.
– They express the reason behind the rule but not the rule itself.
– They have very broad application to a diverse range of circumstances.
– They contain terminology that are qualitative not quantitative, such as “fair”, “reasonable”, and “suitable”) as opposed to a rule, which may state “…within 7 days.”
A classic example of a principle-based provision is found in section 2 of the General code of conduct, which states that a provider must at all times render financial services honestly, fairly, with due skill, care, and diligence, and in the interests of clients and the integrity of the financial services industry.
As illustrated above, principles largely refer to behavioural standards, for example, “integrity”, “skill, care, and diligence” and “reasonable care” with which FSPs conduct and organize their businesses and the fairness with which they treat customers and manage conflicts of interest.
We are fortunate in the sense that there are many business and legal principles in our industry that have been cemented firmly over the decades. The financial services industry has been around for more than 175 years if one considers that Old Mutual was established in Cape Town in 1845 as South Africa’s first mutual life assurance society. This means that, as we approach the promulgation of COFI, we are the beneficiaries of well-established, sound, and even timeless business and legal principles that have sustained successful FSPs for decades. All we need to do is to identify them, understand them, put them in the right context, apply them and implement them – consistently.
Fundamentally, this is a form of management-based regulation, which requires that regulated entities (FSPs) engage in their own planning and internal rulemaking efforts aimed at the achievement of specific outcomes, which is sometimes considered to be “performance-based.” Under a management-based regulation, an FSP can choose what actions it will take to achieve the regulatory objective. Principles-based regulation therefore provides the opportunity for FSPs to determine the best way to align business objectives and processes with specified regulatory outcomes. The FSCA has already published desirable regulatory outcomes in principles and outcome-focused rules in the COFI Bill and they will continue to do so in the conduct standards, which will be published after the COFI Bill is promulgated by Parliament. Since so many best-practice business and legal principles are well-established in our industry, FSPs can proactively start to design their own business and compliance model under COFI.