For several years, the federal government has been enamoured of the notion of principles-based regulation. It has even pledged to adopt this approach if its single national securities regulator comes to pass. Yet, in the face of the financial crisis, the pioneer of principles-based regulation, Britain’s Financial Services Authority, is turning away from the concept.

The idea of trading a rules-heavy approach to regulation for a less intrusive, principles-based strategy has long appealed to the federal government, which sees that as a way to curtail bureaucracy and give businesses more freedom to operate. It has touted a principles-based approach to improving consumer disclosure in the realms of credit cards (the most recent budget) and principal-protected notes (announced in the 2007 budget).

More important, the federal government has also sought to bring the religion of principles to securities regulation. When it struck the latest body to study the whys and wherefores of a single securities regulator — the Tom Hockin-led Expert Panel on Securities Regulation — part of its brief was to examine “how Canada could best promote and advance proportionate, more principles-based securities regulation.”

Not surprising, given the mandate, the panel went on to conclude that a more principles-based model is the way to go. “We are convinced of the merits of this approach and believe that it would improve securities regulation in Canada,” the panel declared in its January report.

It suggested that such a model “will help reduce unnecessary compliance costs, improve regulatory outcomes and give Canada a competitive advantage.”

But despite the ongoing enthusiasm for principles-based regulation in Canada, the FSA — the model’s biggest proponent to date — is now running away from the concept. FSA CEO Hector Sants declared the shift in philosophy in a speech delivered in mid-March.

Sants’ speech noted that in the wake of the financial crisis, the FSA has “significantly modified” its approach: “To suggest that we can operate on principles alone is illusory, particularly because the policy-making framework does not allow it. Furthermore, the limitations of a pure principles-based regime have to be recognized. I continue to believe the majority of market participants are decent people; however, a principles-based approach does not work with individuals who have no principles.”

Instead, Sants has repositioned the FSA’s approach as “outcomes-focused” regulation. This semantic shift echoes a similar move by the British Columbia Securities Commission, an early advocate of principles-based regulation in Canada. In recent years, the BCSC also has adopted the “outcomes” tag.

“At the BCSC,” BCSC chairman Doug Hyndman explained in a speech in late February, “we prefer to use the term ‘outcomes-based regulation’ to describe an approach to regulation that can be more effective than a regime based on imposing prescriptive rules and dictating the internal processes of market participants.”

No matter what it’s called — principles-based or outcomes-focused — the underlying goal is the same: to reduce the regulatory burden on firms by cutting down the long list of specific rules they must follow. But, although that is surely a worthy aim, recent experience suggests that it may not work all that well in the real world — which is why the FSA is moving abruptly in the opposite direction.

In the past, the FSA was careful not to interfere with the business judgment of firms in Britain’s financial services industry. But, in light of the recent financial crisis, the regulator now concedes that markets and financial services firms can’t be left to their own devices — and that the FSA must become more interventionist.

The regulator that once avoided interference is now contemplating a new rule that would require large banks and broker-dealers to implement compensation plans that “promote effective risk management.” Moreover, the FSA recently published a review of banking regulation that calls for sweeping changes, including: tougher capital and liquidity requirements; new regulation for credit-rating agencies and so-called “shadow banking” activities, such as hedge funds; and a shift from focusing solely on firms to supervision of business strategies and systemic risks, among other things.

The FSA’s review identified excessive faith in free markets as one of the primary underlying causes of the financial crisis. It also named macroeconomic imbalances, the illusions of financial innovation and deficiencies in bank capital and liquidity regulations.

@page_break@“The financial crisis has challenged the intellectual assumptions on which previous regulatory approaches were largely built,” says the review’s author and FSA chairman, Lord Adair Turner, “and, in particular, the theory of rational and self-correcting markets. Much financial innovation has proved of little value and market discipline of individual bank strategies has often proved ineffective.”

Although Turner and the FSA haven’t abandoned their belief in capitalism — or in the value of markets — they now recognize that major regulatory reform is required to ensure that markets work properly.

Sants admits that the FSA’s more intrusive approach will carry significant risk and that it could stifle innovation and inhibit economic growth. “However, I believe the revealed preference of society says that this is, and possibly will always be, what society as a whole expects regulators to be doing,” he says. “Indeed, it was what they thought we were doing.”

In Canada, however, the federal government has sustained its passion for principles, even in the face of clear market failures. It introduced its new principles-based PPN disclosure regime after securities regulators became concerned about the increasing complexity of these products, the rising riskiness of their underlying assets and the suitability of their sale to unsophisticated investors (all revelations that came after the collapse of Portus Asset Management Inc.).

Similarly, the feds have pledged to introduce principles-based securities legislation in the face of an unprecedented financial crisis that has damaged the financial services industry’s credibility, revealed the failure of market discipline and undermined the notion of “light-touch” regulation.

A year ago, the U.S. Department of the Treasury was contemplating a similar shift away from rules and toward more “objectives-focused” regulation. That was before the true depth of the financial crisis — and the extent of regulatory failure — became evident. Moreover, these ideas belonged to a previous administration that was ideologically committed to deregulation.

Current Treasury secretary Tim Geithner has signalled that the new administration believes regulation must get tougher, not more flexible. “We must establish a much stronger form of oversight and clear rules of the game, more evenly enforced across the international financial system,” he told the G-20 finance ministers and central bank governors meeting in mid-March, adding that the U.S. Treasury will soon release its regulatory reform plan.

“Our strategy underscores our commitment to encourage a race to the top,” Geithner said in his speech, “rather than a race to the bottom — a global move to higher standards.”

In Canada, the structure of the domestic regulatory system remains the first problem. Numerous efforts to create a national regulator have failed, for reasons that have nothing to do with the content of the proposed regulation. The biggest obstacles to a national regulator are inevitably a lack of political will and provincial intransigence.

Nevertheless, the federal government is committed to giving it a shot. In the Jan. 27 budget, the government pledged to create and fund a transition office that will develop the model and draft a proposed federal Securities Act by the end of the year. According to an official from the Department of Finance, the government is going ahead with those plans now that the budget has passed.

“The process is on track,” the official notes. Candidates for the office are being sought and will be made public once they are confirmed.

Under the terms of the budget bill, which was passed in mid-March, the federal finance minister will have up to $150 million to compensate the provinces that participate and that have to give up regulatory revenue as a result. The transition office will receive up to $33 million to fund its activities; it is to operate for three years.

If this effort is to produce a principles-based model, despite Britain’s apparent repudiation of that model, it will require much more than a new Securities Act and some co-operative provinces to be successful. There will almost certainly have to be a major cultural shift, both at the regulators and within the financial services industry.

Research commissioned by the Hockin panel into the prospect of such a shift recommended that it should be accompanied by mechanisms to improve collaboration between the regulators and the industry; foster increased engagement with consumers and investor advocates; develop a new regulatory culture that matches the new approach; and that it should adopt FSA-style enforcement rather than the more punitive model that is practised in the U.S.

Now, however, the FSA has stated that its more intrusive supervisory stance must also be accompanied by much tougher enforcement. “There is a view that people are not frightened of the FSA,” Sants said in his speech. “I can assure you that this is a view I am determined to correct. People should be very frightened of the FSA.”

If this principles-based type of regulatory innovation is to take place in Canada, therefore, the new regulator will have to find its own way. It can’t simply follow the FSA, which now seems to be abandoning that approach. IE