Reference

Haresh Sapra (Imperial College London), A Model of Principles-Based vs. Rules-Based Standards, Fédération des Banques Françaises Seminar, TSE, July 3, 2017, 12:30–14:00, room MF 323.

Abstract

We develop a model to study the trade-offs between principles-based vs. rules-based standards. By relying on quantifiable evidence, a rules-based standard induces evidence management whereas by relying on management’s professional judgement, a principles-based standard induces abuse of discretion. We show that the optimal standard takes a simple and intuitive form: for sufficiently positive evidence, it relies on the manager’s professional judgement; otherwise, a strict rule is applied. Stated differently, to get a favorable treatment, a transaction has to satisfy two hurdles: the evidence for the transaction must be sufficiently positive and the manager must also exercise professional judgement. We also examine how the optimal standard depends on various features of the firm’s environment.

Research partnership

Fédération des Banques Françaises Research Initiative (sustainable)