Free exchange

Metaphor of the day

A look at the beautiful regulatory regime



the difference between rules-based regulation and principles-based regulation, uses an analogy we can all understand:

Wall Streeters must be soccer fans at heart, because they are huge supporters of the principles-based approach. That should, perhaps, make us skeptical: when the fox applauds ideas for henhouse security, watch out. Yet the European experience suggests that a principles-based system has real virtues. It can make life easier for honest corporations, since they have to spend less time complying with overly complex rules, and also thwart dishonest ones, since regulators can spend more time looking at the substance, rather than the minutiae, of corporate bad behavior. It has been argued that Enron might have found it harder to get away with its shenanigans under a principles-based system, since many of the company’s gambits, while following U.S. accounting rules, nonetheless violated fundamentals of financial reporting. More recently, bank regulators in Italy, following a principles-based strategy, succeeded in keeping big Italian banks from heavily investing in subprime derivatives, even though such investments wouldn’t have broken any laws.

Felix Salmon makes the important point that, "a bad or biased ref can ruin a soccer match in the way that no bad ref can ruin a football match," the lesson being that regulator independence is key in a principles system. He also suggests that the principles-based approach makes soccer the better game, a sentiment much of the world can embrace and which very well might get Mr Salmon beat up in most of America.

At the risk of abusing the metaphor, I wonder if we can't learn something from the kinds of rules abuse seen in the different games. In American football, teams attempt to gain an untoward advantage either through procedural abuse (calling time-outs just before the kicker attempts a field goal--within the rules but annoying), or through carefully orchestrated subversion (the New England Patriots' videotaping of opponents' signals-utterly illegal). In soccer, by contrast, players gain advantage by using situations where referee judgment is required (turning a smallish bump into an impressive flop).

In practice, both systems have experienced difficulty during this latest crisis, and obviously one should expect any regulatory regime to have weaknesses. Given the lower compliance costs with a principle-based system, however, it does seem as though America could learn a thing or two from the Europeans.

And incidentally, basketball is much more a principles-based game than football, which may explain its popularity in Europe.

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