Principlesbased regulation: the implications for regulated firms and compliance professionals

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Principles-based regulation the implications for
regulated firms and compliance professionals

• SHCOG monthly meeting

Martyn Hopper 17 January 2008
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• Ours is an age of substitutes instead of
  language we have jargon instead of principles,
  slogans and, instead of genuine ideas, Bright
  ideas
• Eric Bentley, New Republic (1952)

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Background havent we been here before?

• Principles-based regulation is not new
• Takeover code
• Other forms of professional regulation
• Power to make Principles introduced in financial
  regulation by Companies Act 1989 New Settlement
• FSA implemented current Principles as rules under
  Financial Services Markets Act 2000
• The scheme of the FSA Handbook at N2
• Tiered structure principles fleshed out by
  rules and guidance
• Principles, rules and standing guidance subject
  to consultation and cost-benefit analysis
• Enforcement on the basis of principles would be
  rare

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What is more principles-based regulation?

• Standard-setting
• A move towards greater reliance on broad-based
  standards rather than detailed rules
• Greater reliance on informal FSA guidance
• FSA confirmation of industry guidance
• Outcomes-based regulation
• Increased focus on outcomes
• Outcomes specified in the Principles and by the
  FSA informally
• Greater freedom/flexibility for firms as to how
  those outcomes are achieved
• A more managerial approach to regulation
• Greater onus on firms/senior management to
  determine
• what the Principles/outcomes mean for their
  business
• what particular processes and procedures are
  required to deliver those outcomes
• Construction, implementation and documentation of
  internal review processes is increasingly
  important

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What are the benefits?

• Benefits
• Focus on regulatory goals rather than box
  ticking
• Flexibility for firms
• Better fit with business practices
• More engagement from senior management and
  business
• More efficient regulatory outcomes
• Responsive to changing, innovative markets
• An enhanced role for the compliance team

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Challenges and pitfalls

• Certainty, predictability and consistency
• In standard setting
• In supervision
• In enforcement
• Proliferation of guidance
• Increased reliance on informal guidance from FSA
• Confirmation of industry guidance
• Increased significance of enforcement actions
• Accountability and regulatory creep
• Prescription by the back door?
• Use of informal guidance to effect significant
  change without formal consultation or CBA?
• Blurring the line between minimum standards and
  best practice?

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Challenges and pitfalls (2)

• Legal obstacles
• EC law (e.g. need to implement detailed MiFID
  requirements)
• Possible public law challenge to guidance
• Risk of divergent interpretations of Principles
  by
• FSA
• Financial Services Markets Tribunal
• Financial Ombudsman
• The courts
• Private rights of action?

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But will it work? Principles-based enforcement

• FSA Principle 2 due skill, care and diligence
• Behavioural not outcome based
• Fault based
• How is it enforced?
• Self-assessment/Supervision/Enforcement
• In an enforcement action, FSA must particularise
  breach
• Where does FSA look for standards?
• Other rules and guidance?
• Old rules and guidance?
• Informal guidance / confirmed industry guidance?
• The firms own policies?
• Experts?
• Past enforcement cases?

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What will PBR mean in practice?

• Establishing FSAs expectations is more
  challenging
• Need to keep abreast of broader range of sources
  of guidance DPs, FSA reports on thematic work,
  Dear CEO letters, speeches, industry guidance,
  enforcement decisions etc
• Changes in regulatory policy through
  re-interpretation of Principles
• Change in nature of supervisory relationship
• Developing compliance policies and procedures is
  more challenging
• Simply hard-wiring specific FSA rules into
  internal processes is not enough
• A more holistic, judgemental process
• Engagement of senior management and the business
  is even more critical
• Enforcement
• Use of informal FSA/industry guidance
• Use of firms own internal policies and
  procedures
• Use of industry experts
• Scope for greater debate as to what the
  Principles mean

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PBR A new approach to compliance?
Business Process
FSA Detailed Rules
FSA Principles
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An integrated approach to compliance?



Map Business Process
Map legal and regulatory framework
FSA outcomes
SUPERVISION?
FSA Principles
Detailed rules
FSA/industry guidance
Develop mitigation strategy/controls
Legal duties
Implement and embed
Monitor and Review
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PBR and the compliance function challenges and
opportunities

• Transformation from a functional to a strategic
  role
• Creative compliance encouraged holistic
  judgments required
• Integration of compliance and operational risk
  management?
• Robust approach required when dealing with the
  business
• No refuge in detailed rules
• Promoting business ethics on back of Principles
• Increasing business ownership of compliance
  strategy
• and senior management
• tone from the top
• securing senior management sponsorship
• and the FSA
• - Facilitating businesslike conversations
• - Justifying the firms approach to compliance
  to supervision and enforcement

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Case StudySouthern Stone

• You are the new head of compliance at Southern
  Stone, a boutique investment bank whose 2008-9
  business plan revolves around developing
  innovative products for the wholesale market with
  the potential for them to trickle down to retail
  clients via Southern Stone's existing network of
  distributors.
• One of the offerings currently under development
  is a new structured product the Rocking Stone
  Investor Note a financial instrument combining
  (1) an 80 investment in fixed income products
  created as a result of securitising the cash
  flows generated by royalty payments to the bank's
  recently-acquired portfolio of rock and pop back
  catalogues and reality TV show production
  companies and (2) a 20 investment in an embedded
  derivative linked to the performance of a defined
  basket of stocks drawn from the consumer services
  and telecommunications sector. It is intended
  that the nature of the assets securitised will be
  a powerful selling point to the retail market
  which Southern Stone hopes to access through its
  distributor network.
• Southern Stone is not known for its compliance
  culture. The compliance department is currently
  understaffed. However, a narrow escape and an FSA
  private warning after last year's ARROW visit
  made the main board sufficiently uncomfortable to
  fire its previous head of compliance and poach
  you from a rival, and your mandate is to "ensure
  that there are no remaining cans of worms by the
  time the FSA start poking around again this
  autumn". Despite this the credit crunch has
  complicated matters further only last week you
  arrived for a meeting with Southern Stone's CEO,
  Arthur Bilious, who slammed his door in your face
  muttering " the last thing I need in this market
  is to hear from Compliance"

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Case study (continued)Southern Stone

• It's Wednesday afternoon. Whilst in the middle of
  a memorandum to the FD, Felicity Largepile,
  setting out your case for an increased compliance
  budget for 2008-9, you receive a call from Ivana
  Bonus, the head of structured products, inviting
  you to a planning meeting next Tuesday on the
  Rocking Stone Investor Note. She wants you to
  "greenlight the product" from a regulatory
  perspective and to assure Southern Stone's New
  Product Committee that there will not be any
  adverse regulatory exposure to Southern Stone,
  reputational or financial, arising from the
  marketing of the Rocking Stone Investor Note.
• What risks does "Rocking Stone" potentially
  present when viewed against the FSA's Principles
  for Businesses?
• How are you going to assess/ mitigate those
  risks?
• What steps do you need to take before the
  planning meeting?
• What will you need to do to demonstrate and
  assure compliance
• (a) internally
• (b) to the FSA?
• What changes will you recommend to the Board for
  implementation prior to the next ARROW visit in
  the autumn?

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