OSC Burden Reduction Initiative – Focusing on ‘Principles’ for more responsive and effective regulation

This is the fourth in a series of blog posts examining the Ontario Securities Commission’s (“OSC”) Burden Reduction Initiative. Click here to read the first post which summarized the OSC’s three roundtables held in spring 2019, here to read the second post which focused on the differences between principle versus rule-based regulation, and here to read to third post which revisited Ontario’s 2003 Regulatory Burden Task Force.

The Ontario Securities Commission’s Burden Reduction Initiative emphasizes the centrality of a risk, outcomes, and principle-based focus to effective capital markets and financial regulation.  But what does that mean and look like in practice?  How can that approach be most effectively operationalized?

The UK capital markets regulator was an early advocate of a clearly articulated approach to principle-based regulatory policy, and was met with some headwind when it rolled up its sleeves and pursued that approach.

Challenges for principle-based regulation in the UK in the wake of the 2008 financial crisis

Between 2001 and 2013, the Financial Services Authority (“FSA”) was the single regulator for all financial institutions in the UK and followed a principle-based approach. However, the 2008 Financial Crisis triggered renewed debate about the values of principle-based regulation (“PBR”) and a major regulatory reform.

PBR was seen by a number of critics as supporting the conditions that led up to the 2008 Financial Crisis. Hector Sants, chief executive of the FSA from July 2007 to June 2012, commented that a “principles-based approach does not work with people who have no principles.”

However, hindsight and further reflection has turned attention to the particular manner in which PBR was adopted and how regulatory resources were deployed, rather than on the underlying approach.

• Insufficient Resources: Critical commentary on PBR in the UK emphasized the problems of insufficient regulatory capacity. The failure of Northern Rock, a major British bank, was one of the most striking and surprising events of the 2008 Financial Crisis. An internal FSA report emphasized inadequate resources devoted to overseeing the institution, including high personnel turnover. An important lesson to draw from the UK experience is that PBR makes considerable demands of regulators and financial firms’ internal management.
• “Hands Off” Approach: Many criticisms of PBR in the UK characterized it as a “hands-off” approach to regulation. The aforementioned FSA report also cited limited direct contact with the institution (none of the three FSA department heads responsible for Northern Rock met with the bank in the 31 months prior to its failure in August 2007), and a failure to push management at the bank to modify its business model. PBR does not necessarily involve a light touch; however this can be the result if regulators are not appropriately engaged and thus place undue faith in financial institutions.

Response to the 2008 financial crisis

The Turner Review

In 2009, Lord Adair Turner published The Turner Review: A Regulatory Response to the Global Banking Crisis (the “Turner Review”). The report emphasized the importance of focusing on systemic risk and sustainability; called for more effective regulation, supervision, and systemic oversight; and highlighted the value of harmonization with other regulatory authorities.

• Focus on Systemic Risk: The Turner Review highlighted the importance of ensuring that key stakeholders are properly incentivized to manage risk. Risk-based regulation is inherently complex and difficult for regulators to accomplish without the participation of industry. Effective PBR requires firms to think through the application of broad regulatory provisions in specific situations in a far more comprehensive way than under a rules-based approach.
• More Stringent Regulation: The Turner Review called for more stringent substantive regulation generally, and for regulators to focus more on “high-impact” firms in particular. In the wake of the 2008 Financial Crisis, the FSA was abolished, and its regulatory functions were restructured. This reform was largely motivated by a desire to enhance the supervision and oversight of banking and financial institutions. The reform divided the FSA’s responsibilities between two entities and restored a greater degree of regulatory authority to the Bank of England.
• Harmonization: The Turner Review called for harmonizing regulatory efforts with Europe and valuing coordination between regulatory authorities outside of the UK, including a move towards international regulatory standards.

Lord Turner emphasized the harmonization efforts because the international nature of the Financial Crisis revealed the impact of globalization on the evolution of systemic risk in the financial industry. In the same light, the Chancellor of the Exchequer presented a report on “Reforming Financial Markets” to Parliament in 2009, which drew attention to the failures of the regulatory system to understand systemic risk and to respond to financial globalization and innovation.

Changes to the UK approach to PBR

Today, regulatory responsibilities are split between the Financial Conduct Authority (“FCA”) and the Prudential Regulation Authority (“PRA”). The FCA is a regulatory body that operates independently of the UK government and is responsible for regulating financial firms and maintaining the integrity of financial markets. The PRA operates as a limited company wholly owned by the Bank and England and is responsible for regulating banks, building societies, credit unions, insurers, and major investment firms.

In response to the Financial Crisis, UK regulatory reform moved away from the language of PBR, calling, instead, for more “outcome-based” approaches. Commentators have since reflected that outcome-based approaches are not inconsistent with PBR, but actually a form of PBR as they rely on broad principles, rather than detailed prescriptive rules. An outcome-based approach requires firms to commit themselves to the fundamental goals of regulation and to internalize regulatory requirements.

Although the UK continues to rely on a form of PBR, its regulatory system still has extensive financial rules. This underscores the idea raised earlier in this series, that PBR is not an all or nothing approach, and that rules still play a key role in a effective principles-based regulation.

Final reflections on the current OSC Burden Reduction Initiative

Throughout this series we have repeatedly emphasised four themes:

1. A principle-based approach to regulation, focused on risk and outcomes, is more flexible, responsive and adaptable. Although PBR has faced criticism, the most effective regulators have increasingly tended towards this approach in light of rapid innovation and increased globalization in the securities industry. In the current context, many commentators no longer view a purely rules-based approach as a workable approach to regulation.
2. PBR is not a panacea for the challenges of financial regulation. As the UK’s experience demonstrates, regulators must have adequate resources and staff to achieve an appropriate level of supervision for PBR to work effectively. Regulators should strike a balance that avoid the dangers of a completely “hands-off” approach, without falling into the innovation-stifling rigidity that PBR strives to avoid.
3. Regulators and governments ought to pull up their sleeves to further harmonize regulatory priorities, requirements, and approaches through cooperation and coordination across geographic and regulatory jurisdictions. The benefits of the OSC’s Burden Reduction Initiative will be limited if its most thoughtful recommendations are not shared and appropriately implemented by all who regulate the same market activities and players.
4. Regulators must collaborate with industry and other financial regulators and work towards and articulate a shared set of priorities and desired outcomes.

Taken together these lessons offer insight into the potential advantages and challenges for regulators and members of industry alike. We will continue to monitor the OSC’s Burden Reduction Initiative to see what path the OSC takes and recommendations it makes.

*One of the authors, Lawrence E Ritchie, is a member of the Board of Directors of the Financial Services Regulatory Authority of Ontario (‘FSRA”).This article reflects his own views, and not necessarily those of FSRA.*