Jim Surowiecki gives the best description of the difference between rules-based and principles-based regulation, and why a principles-based approach makes sense, that I’ve yet seen:
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.
One of the interesting things about the soccer-football comparison is that among the small group of people who like both sports, soccer is almost universally considered the better game. Both can be exciting, of course, and both can be very boring. But at its best, soccer has an elegance, fluidity, and beauty that (American) football can never approach. On the other hand, at their worst, soccer matches reach levels of disastrousness that are unheard-of in football.
Surowiecki’s main point is that there’s no point switching to principles-based regulation unless you have well-funded and independent regulators. To continue his analogy, a bad or biased ref can ruin a soccer match in the way that no bad ref can ruin a football match. Given the amount of regulatory capture which has occurred in the US, it makes sense to sequence things: first make sure your regulators are independent and well-funded, and then move them over to a principles-based approach. A principles-based regulator without any teeth is the worst of all possible worlds.