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A Football vs. Futbol Analogy

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James Surowiecki, writing in The New Yorker, makes a great sports analogy of the difference between principle and rules-based regulation. Here’s the bulk of it:

It’s something like the difference between football and soccer. Football, like most American sports, is heavily rule-bound. There’s an elaborate rulebook that sharply limits what players can and can’t do (down to where they have to stand on the field), and its dictates are followed with great care. Soccer is a more principles-based game. There are fewer rules, and the referee is given far more authority than officials in most American sports to interpret them and to shape game play and outcomes. For instance, a soccer referee keeps the game time, and at game’s end has the discretion to add as many or as few minutes of extra time as he deems necessary. There’s also less obsession with precision—players making a free kick or throw-in don’t have to pinpoint exactly where it should be taken from. As long as it’s in the general vicinity of the right spot, it’s O.K.

Wall Streeters must be soccer fans at heart, because they are huge supporters of the principles-based approach. That should, perhaps, make us skeptical: when the fox applauds ideas for henhouse security, watch out. Yet the European experience suggests that a principles-based system has real virtues. It can make life easier for honest corporations, since they have to spend less time complying with overly complex rules, and also thwart dishonest ones, since regulators can spend more time looking at the substance, rather than the minutiae, of corporate bad behavior. It has been argued that Enron might have found it harder to get away with its shenanigans under a principles-based system, since many of the company’s gambits, while following U.S. accounting rules, nonetheless violated fundamentals of financial reporting. More recently, bank regulators in Italy, following a principles-based strategy, succeeded in keeping big Italian banks from heavily investing in subprime derivatives, even though such investments wouldn’t have broken any laws.

The United States, for a long time, has based its regulatory system around rules (often called “bright lines” in accounting theory literature). Movements towards the use of International Financial Reporting Standards (IFRS) throughout the world have marked a trend away from the bright lines used in American regulation towards the use of principles. This requires judgment on the part of management, auditors, regulators, etc., but brings great benefits with it–chiefly reductions in cost realized for companies with track records of compliance and earnings. Its a very interesting topic, but its sheer depth is way beyond the scope of a single post.

Surowiecki goes on to mention how American regulators have had difficulties regulating recently, which is key to a successful principals-based system:

In recent years, regulatory failures have occurred less because of bad rules than because of bad regulators. This is partly because Congress, following the Bush Administration’s lead, has underfunded regulatory agencies.

The debate over which is better is sure to continue, just like my none-too-healthy following of both football and soccer.

Hat tip: Free Exchange (The Economist)

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Written by walonline

April 22, 2008 at 3:01 pm

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