Rules vs Principles Based Financial Regulation

We study the relative strengths and weaknesses of principles based and rules based systems of regulation. In the principles based systems there is clarity about the regulatory objectives but the process of reverse-engineer these objectives into meaningful compliance at the firm level is ambiguous, whereas in the rules based systems there is clarity about the compliance process but the process of forward-engineer this into regulatory objectives is also ambiguous. The ambiguity leads to social costs, the level of which is influenced by regulatory competition. Regulatory competition leads to a race to the bottom effect which is more harmful under the principles based systems. Regulators applying principles based systems make dramatic changes in the way they regulate faced with regulatory competition, whereas regulators applying rules based systems make less dramatic changes, making principles based regulation less robust than rules based regulation. Firms prefer a rules based system where the cost of ambiguity is borne by society rather than the firms, however, when faced with regulatory competition they are better off in principles based systems if the direct costs to firms is sufficiently small. We discuss these effects in the light of recent observations.