Inflexible rules are made to be broken

Charles Dallara, the managing director of the Institute for International Finance in Washington, DC, pulls no punches in our cover profile this month. He says there are elements of the financial services industry that are broken, and need fixing. But he also believes regulators need to rethink their approach to supervision.

For example, he advocates a move to a more principles-based approach in the US and elsewhere, but thinks there is room for rules in some areas. He says, "There really is room and need in most supervisory and regulatory structures for a combination of both principles-based and rules-based. I don't think it's just a matter of retail versus wholesale. I think every good regulatory structure and system will need some overarching principles that guide it. Then, in certain selected areas, whether it's anti-money laundering (AML) or whatever, you will need a set of somewhat more definitive rules. I would say the trend is towards principles-based, and it should be towards principles-based, because of the complexity of the world we live in."

"The problem with rules," he continues, "is not their precision; it is their rigidity. This is what we see time and again – the prescriptiveness inherent in rules simply does not allow for the adaptability and evolution that is needed in today's rapidly changing financial marketplace. The more you build rule-based systems, the more you are in constant need of change, or you end up with serious segments of your supervisory and regulatory structure becoming anachronistic. I believe that we need to move out of detailed legislation and rules as soon as we can."

Dallara adds that jurisdictions that embed too much banking or financial services regulation in legislation are even more likely to have inefficient regulatory structures. "As we all know, it's difficult enough to get regulators to change one of their own rules. It's even more difficult to reopen legislative issues."

A case in point is the US's anti-money laundering framework. "Our money laundering regulatory structure is, to a significant extent, embedded in legislation and this inhibits practical application of a regulatory system that should be risk-based," he says. "It makes it all the more difficult to move towards both a risk-based and a principles-based approach."

And the problem is not confined to the US – it is a global one that the Financial Action Task Force is trying to address. He adds, "regulators need to regain control of AML regulation".