Earlier this year, Nova Credit reported that its application for a license from the United Kingdom's financial regulator, the Financial Conduct Authority (FCA), had been successful.
Seeing a U.S. organization subject to regulation in the U.K. got me thinking about these two countries' completely different systems and how they approach regulation: rules-based vs. principles-based.
Would it be more intuitive for a U.S. organization to go into the U.K. market, or vice versa? What's certain: the firm is forced to wear both hats. However, as much as anyone can disagree, it feels that going from 'box ticking' to thinking in principles is a brave shift. The inverse direction is likely to pose fewer challenges: you are more likely to follow the rules out of principle.
In the principles-based approach, you remain flexible, and you establish general principles. Organizations are given the freedom to implement principles in their own way. With that freedom comes the responsibility of looking at how your organization can best achieve what a regulator wants from you. In doing so, the responsibility shifts to the organization to understand the rule and to effectively comply with the principles.
On the other hand, rules-based regulation sets specific rules and regulations for organizations to follow. This approach provides a clearer understanding of what is expected, so that implementation of the regulations is achieved more easily.
From the perspective of enforcement, a rules-based approach makes things easier, as there is less room for interpretation. However, the regulator casts a smaller net, so necessary flexibility may be missing. Considering how rapidly technology, products, and demand change, it can also stifle innovation and limit the ability to adapt to changing circumstances.
The rules-based approach almost infers a lack of trust in the participants to think for themselves. Principles-based regulations encourage organizations to consider the overall impact of their actions and make ethical and responsible decisions. And that is increasingly important in an industry that is constantly evolving, with technology and new developments that can very quickly render a rule obsolete. In a principles-based setting, innovation is done while taking ownership, with compliance efforts and risk intertwined and proactively addressed in business operations.
In contrast, in more established areas of the financial markets where little change happens, rules-based regulation makes it easier for parties to enter the market. But it could be said that there, best practices would have come to exist across the industry.
When viewed from a broader perspective, U.K. and U.S. regulators want to achieve the same objectives; so why are they going about it so differently? The bodies that regulate the financial markets are fundamentally different, with different histories. It is almost unavoidable they would have different approaches to regulation.
In the U.K., the FCA and the Prudential Regulation Authority (PRA) are the two main regulatory bodies. The PRA has a more supervisory role, responsible for the oversight of individual financial firms. The FCA, on the other hand, regulates 50,000 organizations and was created after the financial crisis of 2008. Its mission is to regulate financial services providers and products, to and protect consumers from financial harm.
In the U.S., agencies regulating financial markets are greater in number. They include the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the Consumer Financial Protection Bureau (CFPB), the Federal Reserve, and other state-level regulators. The main player is the SEC: it was established in response to the Wall Street crash of 1929. Now, the agency enforces federal securities laws and regulations, and protects investors from fraud and other financial misconduct.
A slightly different animal, FINRA (Financial Industry Regulatory Authority), is a self-regulatory organization tasked with regulating brokerage firms and their registered representatives in the U.S. Its main goal is to protect investors and maintain market integrity. FINRA is funded by the firms it seeks to regulate and is supervised by the SEC.
With so many U.S. agencies with their own different objectives, a principle-based approach may be too difficult to achieve. Having a similar starting point in the U.K., the FCA came out of the FSA (Financial Services Authority) and consolidated responsibilities of other bodies. A similar consolidation effort may not be a cultural fit for the U.S., considering the country's long history of federalism with many powers residing with states.
As much as their overarching objectives may be similar, regulators push different agendas. The FCA promotes competition in the financial services sector whereas the SEC tends to protect the interests of investors. The principles-based regulator looks to drive behaviour and takes on a more proactive approach, whereas rules-based regulators tend to be more interventionist and depend on their enforcement abilities for bringing about change.
The levels of fines imposed reflect that. In the U.S., fines imposed by regulators tend to be much higher than in the U.K. For example, in 2019, the SEC fined Goldman Sachs $1 billion for its role in the 1MDB scandal, while the FCA fined the bank £102 million for the same incident. This difference in fines can be attributed to the different legal systems in the two countries. The U.S. operates under a civil law system, allowing for higher fines, while the U.K. operates under a common law system, which tends to be less punitive.
As much as fines may correct the damage on an individual level, market integrity is inherently there or not. It is either woven into the way in which organizations operate, or not. And the deterrent force of high fines often linked to the rules-based approach leaves more to be desired.
It will be worthwhile to follow how an organization, like Nova Credit, fares in the U.K. market. With the U.K. regulators' reputation of being the best in class, meeting its high bar may very well be a precursor to entering other European markets.
