Regulatory competition and rules/principles‐based regulation

• Published date: 01 July 2018
• Author: Norvald Instefjord,Pascal Frantz
• DOI: http://doi.org/10.1111/jbfa.12313
• Date: 01 July 2018

DOI: 10.1111/jbfa.12313

Regulatory competition and rules/principles-based

regulation

Pascal Frantz1Norvald Instefjord2

1Departmentof Accounting, London School of

Economics,UK

2EssexBusiness School, University of Essex, UK

Correspondence

NorvaldInstefjord, Essex Business School,

Universityof Essex, Wivenhoe Park, Colchester

CO43SQ, UK.

E-mail:ninstef@essex.ac.uk

JELClassification: G28

Abstract

This paper analyses how regulatory competition affects principles-

based and rules-based systems of regulation. Competition between

regulators creates the possibility of regulatory arbitrage that gener-

ates a race to the bottom by regulators that is socially harmful. We

derive the welfare effects of such competition and the regulatory

response to these effects, in particular, regulatory harmonisation.

We find, however,that regulators can adopt harmful regulatory har-

monisation. These effects can make coordination efforts in develop-

ing global regulation socially desirable. We demonstrate, moreover,

that corporate lobbying is not alwaysharmful: it can both encourage

and discourage socially desirableregulation.

KEYWORDS

corporate lobbying, principles based regulation, regulatory arbi-

trage, regulatory harmonization, rules based regulation

1INTRODUCTION

This paper analyses how competition between regulatory jurisdictions affects principles-based and rules-based sys-

tems of regulation. These systems are well known in the areas of financial and accounting regulation but to our knowl-

edge there is little research on the effects of regulatory competition. The model consists of two regulators regulating

their own jurisdictions, with firms migrating between the jurisdictions to maximise profits. Regulation is socially bene-

ficial but costly for firms to comply with, so even when regulators maximise the welfare within their jurisdiction, they

face a trade-off between regulating firms sufficiently robustly and driving business away.

The financial crisis in 2007–2008 highlights the need for analysis of this problem. Some commentators have

asserted, for instance, that a “London loophole”with regulation based on vague principles could attract financial busi-

ness.1In parallel to the debate about financial regulation, questions have also been raised about accounting regula-

tion, in particular whether accounting reporting has reflected the underlying economic reality in many financial insti-

tutions.2UK's financial regulatory framework from the late 1990s and early 2000s and the International Accounting

Standards (IAS)/International Financial Reporting Standards (IFRS) represent examples of principles-based systems

1AIGis a prime example; see, for instance, Financial Times, 29 July 2012: Finance: London'sprecariousposition.Since then the UK has indicated a greater reliance

onrules as a means of strengthening regulation. See Financial Times, 13 December 2010: Sants signals shift to rule-based regulation.

2Adiscussion of principles-based accounting standards can be found in Carmona and Trombetta (2008).

818 c

2018 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2018;45:818–838.

FRANTZ ANDINSTEFJORD 819

of regulation. The Federal Reserve'sfinancial regulatory system in the US and the US Generally Accepted Accounting

Principles (GAAP) are examples closer to rules-based systems. The lack of analysis of regulatory competition in this

context motivates our research. Our main finding is that regulatory competition leads to a race-to-the-bottom effect

becauseof the threat of regulatory arbitrage. Regulatory harmonisation can prevent regulatory arbitrage and is chosen

in equilibrium. However,we can have “bad” harmonisation to the wrong system or “good” harmonisation to the right

system. If the regulators are otherwise indifferent in autarky,the wrong system is the principles-based system and the

right system is the rules-based system. Regulatory competition can therefore lead to complicated and counterintuitive

effects that should be taken into account when developingand coordinating global regulation.

In the area of financial regulation, a key objective for regulators is to protect society from systemic corporate fail-

ures in the financial system. In the area of accounting regulation, an objective is to protect society from harmful mis-

reporting of financial information. Corporate failures can threaten the financial system, and misreporting can lead to

social losses for third parties basing their decisions on misleading information. Therefore, it is in the interest of soci-

ety that regulation can minimise the social costs of such events. The principles-based and rules-based accounting sys-

tems are workhorses that form the basis for regulation. Regulatory competition is perceived as a problem because it

leads to a race-to-the-bottom effect that weakens regulatory oversight. This is not a given, and indeed some believe

that regulatory competition can strengthen standards. The Goldman Sachs (2009) report on financial regulation

argues, for instance, that the development of financial centres such as Singapore and London is in part built on strong

regulation.

The following outlines our understanding of the key features of the two systems. A principles-based system is spe-

cific about the regulatory outcomes. Firms must document to the regulator how their actions achieve these outcomes.

There is no ambiguity about the outcomes of regulation but some ambiguity about the regulatory process and whether

the firms'actions are sufficient to achieve the outcomes, because it is the firms themselves that providethe documen-

tation for compliance. The process is therefore imperfect and leads to regulatory failures. In contrast, a rules-based

system is specific about the regulatory process. The firms are regulated according to a specific set of rules and the

regulator decides what set of rules best achieves the regulatory objectives. There is no ambiguity about the regula-

tory process but some ambiguity about whether the outcomes are met, leading to regulatory failures. The failures are

different in nature in the two systems, which makes the analysis non-trivial.

Our analysis is based on two crucial assumptions. First, the regulators are independent and there are limits to their

powers. The regulator cannot implement both a principles-based and a rules-based system at the same time, so some

ambiguity associated with regulation will always remain. The regulators are unable to pre-commit to regulation that ex

ante would be jointly welfare maximising since ex post they independently may want to deviate from such commitment

in order to attract business from each other. Second, firms havefull discretion in choosing their regulator. By reloca-

tions, reorganisations or simply changing the regulations by which they operate, firms can decide which regulatory

jurisdiction they belong to. Such action, labelled regulatory arbitrage, can reduce the cost of regulation for firms and

creates, in effect, a competitive environment for the regulator.Desai (2009) argues, for instance, that factors linked to

regulation can explain the structure of global firms. Regulatory arbitrage is often subject to negative press coverage,

but whyit should necessarily be harmful is unclear. This view is reflected in the Goldman Sachs report (2009) on regula-

tion. Therefore, we need to look at regulatory competition in an equilibrium model where the incentives for regulatory

arbitrage and the regulators'welfare concerns are both recognised. In a study of tax havens,for instance, Desai, Foley,

and Hines (2005) find that the commonly held assertion that tax havens divert economic activity from nearby non-

havens is not consistent with data, which illustrate that issues of this kind can be more complexthan intuition tells us.

The fact that we use an equilibrium model implies that the socially harmful effects of regulatory competition can be felt

evenif regulatory arbitrage activity does not actually take place in equilibrium. Optimal regulation does not necessarily

prevent regulatory arbitrage, and conversely,the fact that regulatory arbitrage takes place does not necessarily imply

that regulation is not optimal.3

3Theview that regulatory arbitrage is harmful in itself is, for instance, expressed clearly in Moshirian (2011).