Rule- versus principle-based regulation

One of the strongest criticisms against the RBI is that it still adheres to rule-based regulation. There is a plethora of rules that players in the system are expected to follow. This inhibits risk-taking and innovation. Indeed, this was one the points made in the recent report on the creation an international financial centre in Mumbai (on which I had commented earlier).

Advocates of principle-based regulation point to the success that the FSA has had in UK.- it will intervene only if a situation warrants such intervention, say, if certain undesirable outcomes have resulted. In the FT, Peter Wallison argues that it just won't work in the US for a number of reasons. Some of those reasons apply to India as well. A key issue is that principles- based regulation confers huge discretionary powers on the regulator- you can't tell what will provoke intervention. The potential for misuse in a context such as India's is enormous.

In a principles-based system, how a principle will be applied remains at the discretion of the regulator. Thus, ironically, given any regulation at all, a rules-based system offers more freedom for those who are regulated.

But apart from this, principles-based regulation reduces the rules transparency essential for a competitive market. A rules-based regime tells everyone what is required to enter a field and compete. A principles-based regime is open to interpretation by a regulator and could be used to deny entry to would-be competitors. A recent example is Wal-Mart’s effort to acquire a bank-like entity known as an industrial loan company. The US banking industry strongly opposed this and – even though there was no legal authority to do so – the FDIC, under industry and congressional pressure, imposed a one-year moratorium on applications by retailers such as Wal-Mart to give Congress time to enact restrictive legislation.

If this is what occurs when there is no authority at all to restrict entry, imagine what would happen in a principles-based environment where a regulator has the discretionary authority to interpret its regulations so as to prevent new competitive entry.

These considerations apart, Wallison contends that in a litigious country such as the US, the absence of clear rules leaves the door open for unlimited private class actions. Americans file suits even when there are clear rules. Where the rules are broad, imagine the good times for lawyers!