Parsing Paulson.(The Talk of the Town)(Henry Paulson)

In the wake of a crisis, the natural response of government officials is often to offer up new rules and regulations. So it came as no surprise when, a few weeks ago, Treasury Secretary Henry Paulson proposed a new regulatory scheme for the nation's stricken financial markets. What was surprising was the scope of the plan. Instead of simply trying to target the practices that helped spark the current crisis, the plan--which has actually been in the works for more than a year--calls for a major overhaul of the American approach to regulation.

As the press has noted, the plan would consolidate our myriad and overlapping regulators into fewer, bigger ones. But the most interesting thing about it is something subtler: a push to move from our current system of regulation--often known as "rules-based"--toward a "principles-based" approach. In a rules-based system, lawmakers and regulators try to prescribe in great detail exactly what companies must and must not do to meet their obligations to shareholders and clients. In principles-based systems, which are more common in the U.K. and elsewhere in Europe, regulators worry less about dotted "i"s and crossed "t"s, and instead evaluate companies' behavior according to broad principles; the U.K.'s Financial Services Authority has eleven such principles, which are often deliberately vague ("A firm must observe proper standards of market conduct"). This approach gives companies more leeway in dealing with investors and customers--not every company needs to follow the same rules on, say, financial reporting--but it also gives regulators more leeway in judging whether a company is really acting in the best interests of shareholders and consumers.

In practice, of course, these distinctions aren't quite so neat: regulators in a rules-based system still have to interpret the rules, and principles-based systems are hardly rule-free. (The Financial Services Authority, for instance, has thousands of pages of rules and guidance.) But the models do represent genuinely different approaches. 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 ...