Evan Soltas
May 26, 2012

The Principled Regulator?

Securities and Exchange Headquarters Building
Arnold Kling has a fresh perspective on how regulation should be articulated, calling for "principles-based regulation" rather than "bright-line regulation":

When we think of regulation, we think of specific rules that spell out the boundaries between what is approved and what is forbidden...What I want to propose is an alternative approach...legislation would lay out broad but well-defined principles that businesses are expected to follow.
Kling recognizes a need for some bright-line regulations in some instances, but he implies that regulation (in particular, financial reg.) would be better off if we made a broad move toward principles and away from bright lines.

I agree with him in some respects -- particularly that bright-line regulation is made toothless by creative circumvention efforts which violate the spirit, but not the text, of a regulation. Kling's essay is motivated by the failure of Dodd-Frank to effectively codify important principles of financial regulation -- why not, then, just put the principles themselves into law?

While I like the idea, I'm very concerned that principles-based regulation may perform even worse than bright-line regulation.

My problems with principles-based regulation are that could establish due process rights where it may be more effective to draw bright lines, that it could create considerable regulatory and political uncertainty, that it would make markets less efficient due to imperfect information, and that trying to establish principles goes far beyond minimalist "rules of the road."

The problem of due process

When firms violate regulations, the regulations can often be enforced without turning to courts. "Your kitchen has a rodent infestation," the regulator says. "Here's a $500 fine, and you have to close down the restaurant until the rodent infestation is removed and you are re-certified by the Department of Public Health." Only in the cases that the regulator's facts, or his application or reading of the relevant regulation, are challenged do such situations require due process -- that is, the involvement of the judicial system. "That wasn't a rodent, Mr. Regulator, and in any case, you didn't realize that rodents are allowed in some restaurant kitchens under the conditions specified under §110.A.4 of the Health Code."

Now consider the scope of expansion of due process when regulations move from bright lines to broad principles. "Your kitchen is unclean," the regulator says. "Here's a $500 fine, and you have do close down the restaurant until it is cleaned and re-certified as such." Given that such a decision has an additional interpretation step beyond the facts, this interpretation by regulators can be challenged in Court in the United States. "Is the Department of Public Health's definition of cleanliness reasonable? Did the Department make a reasonable judgement of the cleanliness in this particular instance?" The example of a rodent infestation bright line becoming a cleanliness principle may seem absurd, but as the principles become even less clear -- for example, Kling's "consumer protection," "reckless behavior," or "fiduciary irresponsibility" tests -- they will invite even more due process challenges.

The need to involve courts in regulatory enforcement strikes me as the defeat of the idea of principles itself. In furthering due process, our court system will establish precedent cases to define the details of the principle in question. And at that point, we've merely outsourced the author of lines to the courts, rather than the legislature. It doesn't resolve the question that, at some point, criteria must be identified for regulations or their applications to meet a reasonability test. Judicial involvement, furthermore, seems to me suboptimal, given the fact that legislatures and regulatory bodies are more open to the democratic process and can actively write new law without waiting for a case.

Regulatory and political uncertainty

The most salient advantages of bright lines is that they are bright, and that they are lines -- that is, you know when you're in violation of them. Firms don't necessarily know when they are in violation of nebulous principles. That may mean they are more cautious to expand or adapt in circumstances where they are uncertain of how regulation will be enforced. For example, let's turn to Kling's Capital One case -- could Capital One recommend its own payday lending service, or another one, to its low-income customer with a small credit limit? Capital One might say that the customer had a chance of benefiting from the product -- and you and I might agree, but would a regulator who thought that payday lending was usurious and exploitative? As a result, firms will have to consider whether their behavior can be construed as in violation of regulations, rather than if their behavior runs directly contrary to a bright line.

Using the same Capital One payday lending example, we can see that the views of the regulators matter under principles-based regulation. What about when the political party of administrations changed in the federal, state, and local governments? Would the enforcement patterns of the principle change? For example, would a Republican commissioner of the relevant enforcement agency be different from a Democratic commissioner in how he judges particular actions of firms as consistent or inconsistent with the principles? This is plausible, perhaps even certain to occur. Also, the uncertainty of principles-based regulation opens the door not just for inconsistent and unclear applications of the principle to specific cases, but outright biased cases. The influences acting upon the regulatory agency become a more important consideration when one expands the discretion of the regulators by making them enforce principles instead of bright lines. (Consider the potential for corruption and for bigotry, just off the top of my head.)

Imperfect information and competition

What follows from this uncertainty and due process requirement is a massive headache: imperfect information. When firms do not know how a regulator will judge, they participate imperfectly in markets -- they will put the principles into practice differently, with some, say, having more clean kitchens than others according to their own liberal or conservative definitions of cleanliness, or some being more aggressive in what financial products they try to sell.

With imperfect information, the firms closest to the regulators (read: the big firms which always hire their compliance officials from top positions in government regulatory offices) will have the best information, giving them a distinct competitive advantage over smaller firms with less information.

Just as bright line regulation creates a perverse incentive for firms to try to circumvent and game the text of the regulation, so does principles-based regulation. The problem is inherent to regulation, not to lines, as Kling suggests. I would contend, in fact, that the incentive problems are not fixed -- perhaps even worsened -- due to the considerable scope of interpretation in principles. The game merely shifts, as firm knowledge of how principles are applied becomes valuable.

Regulation and the role of the state

Finally, Kling and I are both sympathetic to the idea that "government is the problem," or is often so in economic regulation. He puts forth the idea of principles-based regulation in hope that it will reduce the regulatory burden incumbent upon firms. The regulatory codes themselves may be shorter -- something I think is important and a strong argument for a limited application of principles-based regulation -- but it does not follow that the regulatory burden has been lessened, or that the involvement of the state in commerce has contracted.

The tests themselves have changed, but the expectations of regulators have not. Kling doesn't say that the goal is to reduce the involvement of the regulatory state, just to change how it operates. Unfortunately, having the state enforce principles is a far more aggressive posture for the state than bright lines. The regulator is no longer setting "rules of the road" -- they are not the state trooper on the side of the road with the speed gun -- they are for all intents and purposes a judge. (See my discussion of due process.) That's considerably more power granted to the state.