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Principles-based regulation

(Article published in the Sept 13, 2006 issue of Manila Standard Today)  

Following the lead taken by the Financial Services Authority (FSA) of the United Kingdom, Philippine regulators of financial entities are taking measured steps away from “rules-based” and towards “principles-based” regulation. The slow haste is understandable because legally we have a long tradition of rules-based regulation of conduct imposed from above and, perhaps as a consequence, a culture of avoidance, if not evasion, that values the dubious skill called “abilidad”.

  But “principles-based regulation” is the current mantra of the financial regulators of the Western world, and like it or not, we have to come to terms with it sooner or later.  As in most cases, facing the matter early and squarely constitutes the better long-term attitude.

  “Principles- based regulation” is presently preached to be the angel that would bring economic growth and development consistent with a relatively wide latitude of action and discretion on the part of the financial entities on how to conduct their business and at the same time affording adequate investor protection through effective enforcement and intense public education.   “Rules-based regulation”, on the other hand, is the devil that is to blame for the thicket of thistles and bristles of regulatory issuances that choke business innovation and stifle private sector initiative, raise to exorbitant levels the cost of doing business, and otherwise cause great prejudice to consumers and depress, if not totally discourage the entry into the economy of investors, both local and foreign.


To assist the understanding of the difference between the two approaches, pardon this, hopefully pedagogically effective, method of caricatured comparison:  “Principles-based regulation” is like Moses’ two tablets of commandments.  Just to be specific, the fifth commandment: “Thou shall not kill.”  That’s it.  Just four words stating the principle that life, yours or others’, is not to be trifled with.

  “Rules-based regulation”, is, like the Revised Penal Code.  Giving the same mandate to respect life, Act No. 3815, as amended, has fifteen articles punishing various ways of killing, such as, just to mention a few, parricide, murder, homicide, infanticide, and abortion. Around this center are provisions nuancing one’s liability depending on factors such as degree of participation, depravity of execution, maliciousness of intention, and personal circumstances, like age and ability to discern.

  The two approaches obviously come from different directions.  If I may hark back to the lectures of Fr. Austin V. Dowd, S.J, on “History of Political Thought” at the Ateneo College of Arts and Sciences, many years ago, “principles-based  regulation” comes from Jean-Jacques Rousseau’s idea that man is a “noble savage”.  On the other hand, “rules-based regulation” proceeds from Thomas Hobbes’ view that man is essentially “nasty and brutish”. The first needs for guidance merely a statement of high principles; the second demands folios of down-to-earth rules laying out the whole slew of whereases, wherefores, whethers, and what thens.

  Necessarily, the contrary philosophical underpinnings translate into different regions of concern in practice.  Thus, principles-based regulation focuses on the ethical achievement of desired results rather than blind adherence to strict process.  The regulators concern themselves, like traditional Chinese medicine, on the general health and balance of the patient, primarily on whether it is adequately equipped with capital and resources to address its risks, rather than on, like Western medicine, the proper functioning of isolated and specialized organs and tissues.  Consequently, the regulated entities must be transparent to the regulators to enable the latter to assess the adequacy of its systems and readiness of the regulated to adjust to its vulnerabilities.  Under a rules-based regulatory regime, the regulated is simply expected to demonstrate objective compliance with measurable standards, keeping to itself its internal capability to face eventualities.

  To protect the public, rules-based regulation relies heavily on spot inspections and audits to determine consistency in compliance levels.  Principles-based regulation on the other insists on adequate and timely disclosures to the public, particularly of the purchaser’s assumed risks, on specific products and services, information given with the backdrop of public education necessary to enable its members to understand and assess the data made available to them.

  Both principles-based and rules-based regulation, however, need to be supported by efficient enforcement.  However, the latter depends on the regulator to carry the big stick; the former, on the other hand, is more receptive to subordinate regulation amongst the industry players themselves who, by definition, are more attune to the needs of the market.

  I argue that the financial system is presently prepared to adopt the regime of principles-based regulation.  In the first place, the legal system, long before it was formally articulated by UK financial regulators, already contain seminal forms of the principles-based conduct.  Take the Civil Code of 1950.  Following the style of roman law (even in those simple times, roman law already required Twelve Tables, ten more than Moses’ tablets!) it has more than 2,000 articles that provide rules on how to behave in a myriad of specific situations.  But, in recognition of the impossibility of having a rule for every conceivable situation, the Civil Code in its early chapter on “Human Relations” articulates the guiding norm for all human behavior whenever wherever.  Art. 16 provides that “every person must, in the exercise of his rights and in the performance of his duties, act with justice, give everyone his due, and observe honesty and good faith.”

  Even the Revised Penal Code, that epitome of rules-based regulation, contains a principles-based mandate found in a singular title, called “Quasi-Offenses” covering only one chapter, entitled “Criminal Negligence” containing just one article, i.e. Article 365 on “imprudence and negligence”.  This article punishes voluntary, but not malicious, conduct characterized by “inexcusable lack of precaution” as circumscribed by the doer’s or non-doer’s “employment of occupation, degree of intelligence, physical condition and other circumstances regarding persons, time and place.”

  Thus, the formal inauguration of the regime of principles-based regulation by the two major pieces of financial sector reform in recent years, namely, the General Banking Law of 2000 (R.A. No. 8791) and the Securities Regulation Code (R.A. No. 8799), does not constitute a totally alien approach to establishing the rules of engagement among players in the financial market. 

              In a later article, I shall argue that the banking sector is most suited, most disposed, and most prepared to accept the change in regulatory approach coming from abroad.  And within the banking sector, the players in the field of trust are the natural leaders for the change.