Oliver Denk, OECD Directorate for Employment, Labour and Social Affairs, and Gabriel Gomes, OECD Economics Department
In a report issued in June 2017, the Trump administration laid out its proposal for overhauling some of the regulations President Obama had enacted with a view to avoiding a financial market meltdown of the kind we saw in 2008. But what do we actually know about how financial regulation has evolved around the world since the global financial crisis?
Bank supervision has certainly been an active area of reform, not only in the US, but in many other countries. The Basel III accord, the new international regulatory framework for banks that is currently being rolled out, is one well-known testimony. Some countries took less well-publicised action to tighten up supervision, not least when oversight existed institutionally but failed to function properly in practice.
Financial policy, however, goes much beyond bank supervision. It also includes aspects such as credit controls, ease of entry into the banking sector, capital account controls and government ownership of banks. The general picture of the 30 years leading up to the crisis was one of liberalisation of domestic and international capital markets, accompanied by efforts to strengthen frameworks for bank supervision. But the various dimensions of financial policy are rarely assessed together, even though they all matter for financial markets, corporations and households.
This is precisely what we have set out to do, as we explain in our new OECD working paper. In fact, we have assembled a novel dataset on financial policies from 2006 to 2015, by building on an index from the International Monetary Fund. The index by the IMF is the most widely used measure of financial reforms in cross-country empirical research, having been used in some 200 publications. The trouble is the IMF dataset was only available up to 2005–so we have effectively extended it by another 10 years. The index has its strength in covering many different types of financial policies, though it is not overly specific on most dimensions.
What do we find? In some areas, financial policy has become less liberalised since the global crisis. Bank privatisation has seen the strongest break in trend. Governments had reduced their ownership in banks over the one to two decades before the crisis. But since then, recapitalisations in a number of countries have increased government ownership and lowered financial liberalisation in this respect, as the chart below shows.
In other areas, financial liberalisation has more or less stayed the same. Take restrictions to international capital movements. By standard measures, these had largely gone in most advanced economies before the crisis. Today, the developed world as a whole is as financially open as 10 years ago. However, some countries such as Chile, Iceland and Slovenia have tightened their capital account restrictions, even if others like Australia, Korea and Turkey have lifted theirs.
Bank supervision efforts continued to strengthen through the 2000s under the Basel accords. In many countries, this has not only changed how capital requirements are set, but also reinforced the way in which supervisory authorities assess prudential reports and statistical returns from banks through on-site and off-site examinations.
On the whole, our data suggest that the financial crisis has not undone the financial liberalisation that was achieved in the preceding three decades or so. However, it remains to be seen whether the renewed state ownership of banks is part of a temporary post-crisis phenomenon or something longer term. Governments do tend to sell off their stakes in banks when they find the opportunity, and a few countries–Austria is a good example–have now unwound their increased ownership in banks, in some cases thanks to liquidation.
Developments have been quite different for emerging market economies, in particular the BRIICS countries*, where financial liberalisation has continued at the same quite rapid pace as before the global crisis. One reason is that entry barriers into the banking sector have been lowered in some cases; other factors include stronger bank supervision and the deregulation of stock markets. Finance nevertheless remains substantially less liberalised in the BRIICS than the OECD, as the graph below demonstrates.
These are just some of the revelations of our new data, which will hopefully allow the many researchers who have been relying on the IMF dataset for quantifying financial policies to delve into an additional 10 years of observations. This is vital for tracking how policy has affected financial systems and the real economy since the crisis. If you are such a researcher and would like to use the dataset, please contact us at any time.
Denk, O. and G. Gomes (2017), “Financial Re-Regulation since the Global Crisis? An Index-Based Assessment”, OECD Economics Department Working Papers, No. 1396, OECD Publishing, Paris
* BRIICS countries are Brazil, Russia, India, Indonesia, China, South Africa.
Harald Stieber, Economic Analysis and Evaluation Unit, DG FISMA, European Commission
The financial crisis of 2007/08 was not caused by complexity alone. It was caused by rapidly increasing financial leverage until a breaking point was reached. While the mostly short-term debt used for leveraging up consists of “run-prone contracts“, the precise location of that breaking point had to be discovered in real time and space rather than in a controlled simulation environment. Also, the complex dynamic patterns that emerged as the crisis unfolded showed that little had been known about how an increasingly complex financial system would transmit stress. The sequence of markets being impacted and the speed of risk propagation across different markets and market infrastructures was not known beforehand and had to be discovered “on the fly”. Our ignorance with respect to these static and dynamic properties of the system reflects deep-rooted issues linked to data governance, modelling capabilities, and policy design (in that order).
From a policy perspective, the crisis revealed that several parts of the financial ecosystem remained outside the regulatory perimeter. As a result, the public good of financial stability was not provided any longer to a sufficient degree in all circumstances. However, the regulatory agenda that followed, under a principles-based approach coordinated at the level of the newly created G20, while closing many important regulatory gaps, also created increasing regulatory complexity.
Regulatory complexity can also increase risks to financial stability. Higher compliance cost can induce avoidance behaviour, which makes financial regulation less effective as regulated entities and agents will engage in regulatory arbitrage as well as in seeking to escape the regulatory perimeter altogether via financial innovation. Until recently, at least the largest financial institutions were considered to “like” regulatory complexity.
However, the perception of complexity in the financial industry is changing. Complexity cannot be gamed any longer as compliance cost and risk of fines have increased. One of the clearest statements in that direction came in the form of a letter from financial trading associations that we at the European Commission received (together with all main regulators) on June 11 2015. In their letter, the associations called for coordinated action in the area of financial (data) standards that would reduce complexity to a level that could again be managed by the sector.
The European Commission’s Better Regulation agenda has at its heart the principle that existing rules need to be evaluated in a continuous manner to assess their effectiveness as well as their efficiency. Under this agenda, the Commission launched a public consultation in 2015 calling on stakeholders to provide evidence on 15 issues with a strong focus on the cumulative impact of financial regulation in place. The purpose was to identify possible overlaps, inconsistencies, duplications, or gaps in the financial regulatory framework which had increased considerably in complexity. The area of (data) reporting emerged as a major area where responses pointed to important possible future gains in regulatory effectiveness and efficiency.
Regulatory reporting has seen massive changes as the lack of relevant data at the level of supervisory authorities had been identified as a major source of risk during the crisis. Especially, legislation in the area of financial markets such as the European Market Infrastructure Regulation (EMIR), but also MiFID/R, employed a different approach to regulatory reporting compared to existing reporting obligations for regulated financial institutions (e.g. COREP, FINREP). EMIR puts the focus on the individual financial transaction (of financial derivatives traded over-the-counter rather than on a regulated exchange), with reporting at the most granular level of the individual financial contract. Reporting under EMIR started to be rolled out in several phases from February 2014 and is still ongoing, starting from the most standardized contracts and continuing to the least standardized ones. This approach is extended to a broader class of instruments under MiFID/R.
This granular approach to regulatory reporting holds tremendous promise from a complexity science perspective. It could, at some point, allow the mapping of the financial ecosystem from bottom-up, as well as further the development of a Global Systems Science policymaking process. However, to arrive at more evidence-based, data-driven policies, data governance, and more precisely financial data standards, will have to be adapted to the increasingly granular data-reporting environment.
Data governance requires robust financial data standards that keep up with technological change. We see a few precise implications at this stage what standards need to do in that respect. Financial contract data is Big Data. Financial data standards produce small data from Big Data. They add structure and scalability in both directions.
In a follow-up project to the call for evidence, we are therefore looking at different ways how financial data standards and regulatory technology can help achieve Better Regulation objectives. These possible ways comprise the definition of core data methodologies, the development of data point models, exploring the use of algorithmic standards, as well as possible uses of distributed ledger and decentralized consensus technologies. We cannot say at this stage if the vision of a “run-free financial system” is within our reach in the medium-term. But the resilience properties of the internet are one possible guide how technology could help regulatory reporting achieve its objectives in a much more powerful way in the future that will at the same time acknowledge the complexity of our subject matter.
OECD-EC-INET Oxford Workshop on Complexity and Policy, 29-30 September, OECD HQ, Paris: Click here to register
 Effectiveness: Does the impact observed on the ground correspond to the outcome aimed for by the EU co-legislators?
 Efficiency: Is the desired regulatory outcome achieved at lowest possible compliance cost?
Mankind created software and technologies reducing every distance, border, and difficulty, pulling the world instantly closer together. But what about finance? Wall Street and financial services have not fundamentally changed in the past fifty years. This thirteen trillion dollar industry relies on services and fee structures from a bygone era. Online financial offerings pale in comparison to our other digital experiences. Technology makes it possible for instantaneous payments, except that right now it takes days, or even weeks to make basic transactions. All this begs the question: why can’t money be digital too?
Ten years ago, people were using Kodak film to develop photos, going to Blockbuster to rent movies, and heading to the local bookstore to pick up the latest bestseller. No one had heard of of the iPhone (because it hadn’t been invented yet) and Instagram, and companies like Netflix were unknown or not yet in existence. The digital world is part of our DNA now, it’s how we consume our entertainment, share our experiences and stay in touch with our loved ones. We are now seeing the emergence of FinTech challenging one of the most entrenched and consolidated industry in existence – finance. FinTech questions the wisdom of the traditional financial sector providing consumers and business more choice, freedom, and access to financial services than ever before.
Today it should be easy for someone based in Berlin to do business with someone in Paraguay; but it’s not. Borders continue to hinder people’s ability to do business globally. While billions of people around the world have no access to financial services whatsoever, many others are dramatically underserved by traditional banks. In 2015, banks in the US alone took in over $31,000,000,000 in overdraft fees. Think about that for just a moment. $31 billion in fees from people who didn’t have any money in the first place. According to recent data from Goldman Sachs, 33% of people who identified themselves as Millennials do not expect to even have a traditional bank account in five years. Between the billions of people without access to financial services and the advent of software to digitize financial services — it is clear there is a seismic shift in both need and consumer expectations.
Things are changing though. Fast. For the first time, we have the technology to meet those needs in the financial sector. The blockchain, the technology that settles and clears transactions on the Bitcoin network, makes it possible to bring billions of people into the global financial economy for the first time.
But what is the blockchain?
The blockchain is a transaction network that uses a distributed ledger and digital currency to settle transactions with a high degree of certainty. The network is decentralized, just like the internet, which means it’s very durable. Anyone in the world can write to the blockchain database but no one can unwind the history.
Blockchains provides three very compelling value propositions for policy makers. They are far more cost-efficient, secure, and transparent. With distributed ledgers there is no need for a central third party to manage the process, ensure version control, or police participants. Despite the lack of a governing third party, blockchains are secure because the infrastructure and incentives built into the network make it virtually impossible to alter transactions after they are confirmed by the network. This makes them censorship proof and far more secure that centralized databases. Finally, blockchains provide complete transparency to participants and outsiders alike.
This technology can democratize access to financial services and enable people who do not know each other to faithfully complete economic transactions without relying on counterparties or intermediaries. To be clear, open source software can do what banks have done for thousands of years.
People are realizing the potential of the blockchain and the bitcoin network it supports. This is clear from the transaction growth in bitcoin over the last few years. The chart below shows the number of transactions on the bitcoin blockchain which is doubling every 12 months.
Now is the time to support the growth of such open and decentralized value transfer networks. Legacy systems are centralized proprietary cost centers. They rely on outdated settlement periods designed in the 1950’s. As consumers demand an increasingly digital experience, payment solutions designed by banks are band-aids which include fundamentally flawed security solutions. Such systems expose consumers to needless risk. According to one study by LexisNexis, fraud costs the U.S. economy more than $190B each year. In 2015, there was an increase in the number of large scale breaches of data. The number of incidents have continued to go up, increasing by more than 10% from 2014 according to a major cybersecurity firm. This is because centralizing data increases the risk of a breach.
Aside from fraud and data breaches, the centralized payment systems of the past have simply not kept up with the need of a global population connecting digitally in ever more complex and constant ways. Before we can get to a world where the Circular Economy and Internet of Things are improving sustainability and driving down the costs of production, we have to have a payments network that can facilitate purely digital transactions. This has very exciting implications for helping reduce corruption and reducing human driven impacts on the climate.
This world won’t come to fruition without a way for people to transact with each other affordably, quickly, and easily. The bitcoin blockchain makes this feasible. For the first time an open, accessible, and fair financial future is possible. The good news is that this technological backbone is being used and adapted allowing millions to connect and transact in ways never thought possible. Much work remains to be done to scale such a network to reach the lives of the billions still outside the financial sector. While businesses, citizens, and new technology companies are experimenting with this technology and making it more usable and accessible, policy makers have a role to play as well. The first step is engaging with this new and powerful system. Inviting current participants, entrepreneurs, and software developers to policy meetings to stay abreast of developments and learn how and when to play a supportive role.
Ministers, the business community, civil society, labour and the Internet technical community will gather in Cancún, Mexico on 21-23 June for an OECD Ministerial Meeting on the Digital Economy: Innovation, Growth and Social Prosperity.
Freedom of choice, bitcoins and legal tender Adrian Blundell-Wignall on OECD Insights
The Force of Finance for Responsible Business: How the financial sector could and should contribute to responsible business conduct
Roel Nieuwenkamp, Chair of the OECD Working Party on Responsible Business Conduct (@nieuwenkamp_csr). This article also includes a contribution by Bob Jennekens, LL.M./M.A. student, Maastricht University Faculty of Law/Arts and Social Sciences.
These days a critical mass of investors promote investment approaches which take into consideration environmental, social, governance (ESG) factors, otherwise known as responsible investment. Investors involved in the ‘Principles for Responsible Investment (PRI) Initiative, a membership based organization which seeks to promote responsible investment, currently manage over $60 trillion in assets.
Responsible investment is not only an ethical consideration but also relevant to managing risks regarding returns on investment as often there will be alignment between salient ESG risks and financial materiality. A wide body of research suggests that responsible business practices can represent a competitive advantage for firms, creating increased returns for investors, while irresponsible practices can pose serious risks and costs. For example, earlier this month investors of ExxonMobil and Chevron voted to support a resolution for a climate ‘stress-test’, signalling that investors view climate change as a material financial risk.
In this context many investors rely on the OECD Guidelines for Multinational Enterprises (the OECD Guidelines) as an important benchmark for responsible business conduct (RBC) for their investee companies. The OECD Guidelines are a comprehensive multilateral agreement on corporate responsibility which are accompanied by a globally active grievance mechanism that aims to resolve issues arising under the Guidelines, including those linked to investments in companies which may be behaving irresponsibly. This mechanism is known as the National Contact Point (NCP) system.
Because they hold the purse strings, investors have the potential to exert substantial influence, or leverage, on their underlying companies. Under the Guidelines institutional investors are expected to conduct due diligence and use their leverage to influence companies they invest in to prevent or mitigate negative impacts they are causing. Similarly, PRI members subscribe to the principle of being active owners of their investments, which in practice also includes engaging with and exerting leverage on investee companies to promote responsible business practices. We have already seen many significant examples of the ‘’force of finance’’ in promoting responsible business practices. In the context of the OECD Guidelines’ grievance mechanism, investors have helped persuade companies to come to a mediated agreement with parties raising complaints and have followed up on NCP statements with recommendations, adding ‘teeth’ to the process. In practice this has resulted in investor engagement to fight forced labour in Uzbekistan, to prevent environmental damage in the Democratic Republic of the Congo (DRC) and to prevent human rights violations in India.
These examples, described in more detail below, have demonstrated that harnessing the “force of finance” can create real market incentives for responsible business and promote respect of non-binding international standards, such as the OECD Guidelines.
The OECD Guidelines and National Contact Points (NCPs)
The OECD Guidelines, affectionately referred to as the grandmother of all corporate responsibility standards, celebrate their 40 year anniversary this year. The Guidelines are a comprehensive set of recommendations directed towards multinational enterprises (MNE’s). While they are non-binding for companies they represent a “firm expectation by governments on company behaviour.”
They are however binding for member states of the OECD, who are obliged to 1) promote the OECD Guidelines amongst MNEs operating in or from their territories and 2) establish National Contact Points (NCPs). NCPs are mandated to promote the OECD Guidelines within their jurisdictions and to serve as the unique grievance mechanism of the OECD Guidelines. NGOs, citizens and other interested parties can refer complaints to NCPs regarding alleged non-observance of the OECD Guidelines, termed as “specific instances.” Specific instance proceedings usually involve mediation between the parties followed by a final statement on the issues.
The role of the financial sector in promoting RBC is increasingly being discussed in the context of specific instance proceedings. Specific instances involving the financial sector have seen significant increases in terms of submissions of complaints, from about 8% of specific instances from 2000-2010 to 17% of specific instances from 2011. Increased attention to expectations of investors to manage environmental and social risks in their underlying companies as well as recognition of the financial materiality that such risks may bring has encouraged investors to take an active role in promoting responsible business conduct. Below we highlight five specific instances to illustrate the potential force of finance in promoting the recommendations of the OECD Guidelines.
Divestment based on poor stakeholder engagement and risks to Indigenous Peoples
In 2009 the UK NCP handled a specific instance involving Vedanta Resources, a diversified metals and mining group, with regard to establishment of a bauxite mine and the expansion of an aluminium refinery in Orissa, India. The NCP concluded that Vedanta Resources had failed to adequately consult indigenous communities about the proposed mine. In response to this finding and the ongoing controversy, some investors made an effort to engage with Vedanta while others disinvested or significantly decreased their stakes in the company. Investors that chose to divest included the Norwegian Government Pension Fund (one of the largest pension funds in the world), the Church of England, the Joseph Rowntree Charitable Trust and more recently, the PGGM, a large Dutch pension fund manager. PGGM noted that it had attempted engagement with Vendanta for two years with regard to its mining activities in Orissa, and that it had met with the company’s management and non-executive directors. PGGM stated however that when it had tried to organise a meeting with a group of other investors: ‘to discuss possible solutions to the problems in Orissa, Vedanta did not accept the invitation to participate.’
Engagement with government regarding human rights and forced labor in the cotton sector
In 2014, the Korean NCP received a complaint alleging that Daewoo International had breached the human rights provisions of the Guidelines by purchasing cotton produced in Uzbekistan despite their awareness of on-going state-sponsored forced labour in the country. The Korean NCP recommended that the company continue to monitor the situation and respond actively to the issues by means of dialogue and co-operation with the government of Uzbekistan, state-owned companies, related international organisations, NGOs, and local communities.
Upon issuance of these recommendations by the NCP the CEO of Daewoo and other senior executives of the company asked the government for consistent efforts to eliminate the risk of forced labor in Uzbekistan. Pension funds from Sweden, UK, Denmark, Poland, etc. have also been engaged with Daeweoo to encourage them to contribute to improved labor conditions in the cotton industry. These major global investors want the company to keep pressing the government of Uzbekistan to introduce risk mitigation measures in this context, for example, independent monitoring of the cotton harvesting.
Exclusions and human rights violations in the mining sector
In 2012 three complaints were filed claiming POSCO, a South Korean steel company had not engaged in meaningful stakeholder consultations and had not respected environmental and human rights standards when establishing a new plant in India. In addition to bringing a specific instance involving Posco’s parent company, two other specific instances were filed implicating pension funds with investments in POSCO. These were ABP, one of the Netherlands’ largest pension providers, and its administrator APG and Norges Bank Investment Management (NBIM).
As a result of the NCP process ABP agreed to use its leverage in the future to bring the operations of POSCO up to the required international standards and proposed organizing a fact finding mission to India to map the adverse impacts. However this fact finding mission was not undertaken and POSCO was effectively excluded from ABPs portfolio. Subsequent to the issuance of a final statement from the Norwegian NCP, POSCO has been included on NBIM’s conduct-based investment exclusion list.
Prevention oil prospecting in a World Heritage Site
In 2013 a complaint was lodged by the World Wildlife Fund (WWF) at the UK NCP against SOCO, a British oil and gas exploration company for its operations in the Virunga National Park in the DRC. These operations were deemed to be contrary to the DRC’s treaty obligations to protect the Virunga National Park as a UNESCO World Heritage Site. WWF also appealed to SOCO investors to engage with the company. The investors, including Aviva, heard WWF’s call and responded by engaging with SOCO to bring it in line with expectations under the OECD Guidelines. Some even called to remove SOCO’s CEO in reaction to the event. As a result of the NCP case and pressure exerted by investors SOCO committed to cease exploration in the park unless UNESCO and the DRC government agree that such activities are not incompatible with its World Heritage status and also committed to “not to conduct any operations in any other World Heritage site.”
Protesting the pharmaceutical sector’s involvement with capital punishment
Recently a case was brought to the Dutch NCP involving Mylan, a pharmaceutical company, for possible human rights abuses associated with the production and sales of rocuronium bromide to the United States for use in lethal injections. In parallel to the specific instance proceeding several investors entered into dialogue with Mylan to persuade the company to ensure that its products are not used to carry out lethal injection executions. ABP had been in talks with Mylan since October 2014 about the use of muscle relaxants in executions in US prisons, however because it felt its requests to alter its distribution systems were not met with an adequate response, ABP decided to sell its shares in the company. Other shareholders, such as ROBECO, PGGM-Pensioenfonds Zorg & Welzijn and NNGroup N.V., indicated their intention to continue the dialogue. Excluding investments was seen to be ‘a last resort that should be used only when all other forms of active shareholdership have not led to the desired result.’ Since the specific instance was first filed Mylan has taken active steps to prevent the rocuronium bromide from being used in US prisons for executions. The Dutch NCP concluded in its final statement for the specific instance that “dialogue as well as disengagement by some [investors] appear to have contributed to improvements in Mylan’s conduct.”
Investors have the power
Investors have significant potential to use the “force of finance” to promote better business behaviour amongst their investee companies. Indeed, applying this leverage is an expectation under the OECD Guidelines as well as Principles for Responsible investment.
These five specific instances represent fascinating case studies of how investors can exert leverage on their underlying companies, either through engagement or divestment, to promote responsible business conduct. In practice, often investor engagement with investee companies is done in confidence and thus likely many more examples of successful outcomes exist. Furthermore, direct engagement and divestment represent only two approaches investors have at their disposal in using the force of finance to promote responsible business practices. Shareholder activism is another potentially effective approach. Recently AFL-CIO, the most powerful trade union in US, introduced a shareholder resolution at seven companies urging them to participate in mediation processes to remedy human rights violations, including through NCPs. Even if these resolutions are not ultimately successful they nevertheless will serve to heighten awareness amongst investee companies at the board level about the NCP procedure as well as importance of these issues for their investors.
While these initiatives and results are promising, active ownership and application of due diligence as promoted by the OECD Guidelines by institutional investors is a trend that is still only in its infant stage. In order to have greater impacts these ESG initiatives will have to be scaled up considerably and global investors will have to collaborate with one another to encourage positive solutions to pervasive challenges in the context of corporate responsibility.
Roel Nieuwenkamp maintains a blog where all of his articles are archived. Please visit https://friendsoftheoecdguidelines.wordpress.com/
 Established per article I, paragraph 1 of the Amendment of the Decision of the Council on the OECD Guidelines for Multinational Enterprises
Before the recent crisis, the biggest failure of a commercial bank in the UK was the City of Glasgow Bank in 1878. The CGB collapse was due to mismanagement and fraud, and the authorities set up a commission of inquiry that recommended a number of measures to improve corporate governance. No they didn’t. They arrested the bank’s directors and sent them to prison, and corporate governance improved remarkably. As this Bank of England paper argues, the CGB collapse had a lasting impact on the financial system, requiring banks to be externally audited, and prompting a move away from unlimited liability banking (too late for William Love, whose newly worthless £200 shareholding exposed him to £5500 liability). The crisis also led to a wave of mergers and the emergence of the banking structure dominated by big banks we know today, as well as a change in risk management, with banks increasing the share of more liquid, lower-risk assets on their balance sheets.
The Bank of England paper discusses the lessons for today from the CGB crisis, and how the financial sector should change. The Bank’s Governor, Mark Carney, came back to the question in a speech last week about “Building real markets for the good of the people”. Carney argues that in the City, “Unethical behaviour went unchecked, proliferated and eventually became the norm. Too many participants neither felt responsible for the system nor recognised the full impact of their actions.” He feels “let down” by this, and explains how it contributed to “ethical drift”. I strongly advise you to use this lovely concept in court next time you’re caught stealing.
Why did they start drifting? It wasn’t to feed their starving children if the data in a new OECD Economic Policy Paper are right. Finance and inclusive growth shows that the finance sector pays better than other sectors, even for workers with similar profiles, and the gap with people doing similar jobs widens as you scale the corporate ladder. The paper doesn’t say whether this is because traders and the like are paid more than they’re worth or because the rest of us are paid less than we deserve. (What do you think, readers?) And in more news, “male financial sector workers earn a substantial wage premium over female financial sector workers, especially at the top”.
Another finding reminds me of a scene in a film with Roberto Benigni when he goes to the bank to borrow money because he’s broke. The banker refuses, explaining that you need collateral. Furious and incredulous, Benigni protests that when he goes to get tomatoes, the greengrocer doesn’t expect him to have aubergines in the house before he’ll serve him. That translates as “The distribution of credit can be an additional source of income dispersion if it implies that low income people cannot finance the opportunities they identify to the same extent as their better-off counterparts”.
These then are the findings most of us would have guessed or noticed anyway. The real surprise in the paper is the argument that there can be too much finance in the economy. The authors show that the extravagant salaries paid to the ethical drifters are only one of the negative consequences of the way the sector has developed. The analysis uses two direct measures of financial activity: the volume of credit provided by financial intermediaries such as banks to the non-financial private sector, and stock market capitalisation.
Over the past half-century credit by banks and other financial institutions to households and businesses in OECD countries has grown three times as fast as economic activity. Stock market capitalisation has tripled relative to GDP over the past 40 years, but today the value of stock markets still only equals 65% of GDP, just over half that of financial sector credit.
The OECD economists looked at how this growth in the financial sector affects growth in the rest of the economy. Initially, an expanding financial sector is beneficial, but it eventually reaches its ideal weight, and apart from contributing to inequality, “further increases in its size usually slow long-term growth”. This conclusion holds even when you consider a range of other factors including country specificities, the business cycle, and even financial crises. In general, more credit to the private sector slows growth in most OECD countries, while more stock market financing boosts growth. Bank loans slow economic growth more than bonds. Credit is a stronger drag on growth when it goes to households rather than businesses.
The long-term increase in credit is linked to slowing growth through five channels, including bank lending increasing more than bond financing, and a disproportionate increase in household credit compared with business credit. The first channel the OECD identifies may however amuse those of you with good memories (or long-held grudges) – excessive financial deregulation. Compare and contrast that with this, from 2008: “Observing the changes that have taken place in the past 25 years, a consensus has emerged that a deregulated financial sector operating in a competitive, open environment with market-based supervision grounded in international norms, is optimal contribution for economic development.”
Still, we admit our mistakes and are trying to learn from them, and even have a whole programme called New Approaches to Economic Challenges (NAEC) that calls for “a serious reflection to revisit policy approaches” in the wake of the crisis. Can the financial sector and the policymakers who influence it do the same? The OECD strategy to reform the financial sector to stop it slowing growth and making inequality worse has three broad components.
First, use macro-prudential instruments (measures that address risks to the whole system rather than individual institutions) to prevent credit overexpansion, and make sure banks maintain sufficient capital buffers. Second, reduce subsidies to too-big-to-fail financial institutions through break-ups, structural separation, capital surcharges or credible resolution plans. Reduce the tax bias against equity financing and make value added tax neutral between lending to households and businesses.
We could also remind the financiers what The Spectator said in arguing against a national subscription to help William Love and the others: “The notion that a grand failure is a pure misfortune, and one for which the partners are irresponsible, is one far too widely diffused already, and one which it is wrong as well as inexpedient to make deeper.”
Too Much Bank Lending Can Slow Economic Growth: OECD Chief Economist Catherine Mann talks about the impact of bank lending on finance practices and economic growth on Bloomberg Television’s “Market Makers.”
Adrian Blundell-Wignall, Director in the Directorate for Financial and Enterprise Affairs, Special Advisor to the Secretary-General on Financial Markets
The greatest puzzle today is that since the global crisis financial markets see so little risk, with asset prices rising everywhere in response to zero interest rates and quantitative easing, while companies that invest in the real economy appear to see so much more risk. What can be happening? The puzzle is even more perplexing when we see policy makers lamenting the lack of investment in advanced countries at a time when the world economy shows all of the characteristics of excess capacity: low inflation and falling general price levels in some advanced countries for the first time since the gold standard and despite six years of the easiest global monetary policy stance in history.
Will financial markets be proved wrong so that asset prices will soon collapse? Or, alternatively, will business investment take off and carry growth and employment to more acceptable levels validating the market optimism? The forthcoming OECD Business and Finance Outlook presents a reconciliation of these apparent contradictions based on the bringing together of new evidence about what is happening in some 10,000 of the world’s biggest listed companies as they participate in global value chains across 75 countries and which represent a third of world GDP. The salient points are these:
- There is plenty of investment globally but from an advanced country perspective it is happening in the wrong places, as global value chains have broken down the links between policies conducted by governments inside their own borders and what their large global companies actually do. Short-termism too is apparent, where investors prefer companies that carry out more buybacks and dividends compared to those that embark on long-term investment strategies. Advanced country companies appear to prefer outsourcing investment risk to emerging market countries in global value chains when they can.
- From a developing country point of view financial repression and exchange rate targeting are legitimate development strategies. Investment is enormous (running at double the rate per unit of sales in general industrial companies compared to those of advanced countries), but it is not well based on market signals and efficient value creation strategies. Instead, it is fostered by cross-border controls, the heavy presence of state-owned banks that intermediate the “bottled-up” savings into investment, local content requirements and pervasive regulations and controls. Over-investment—characterised as a falling return on equity in relation to the high cost of equity that opens a negative value creation gap—is a feature of many emerging market companies which, at the same time, are borrowing too heavily.
- Concern about employment and growth in advanced countries has seen central banks vainly trying to stimulate investment at home: for six years they have kept close to zero interest rates and successive attempts at quantitative easing have been launched in the US, the UK, Japan and Europe. These actions are pushing up the value of risk assets in the search for yield, as pension funds and insurance companies face very real insolvency possibilities (with liabilities rising and maturing bonds being replaced by low-returning securities). The competition to buy high-yield bonds is seeing covenant protections falling, and less liquid alternative products hedged with derivatives are once more on the rise.
- Many of these new products are evolving in what has come to be known as the “shadow banking sector”: as banks themselves have become subject to greater regulatory controls financial innovation and structural changes in business models are once again adjusting to shake off the efforts of regulators. Broker-dealers intermediate between cash -rich money funds on the one hand, which need to borrow higher-risk securities to do better than a “zero” return, and cash-poor institutional investors on the other, that need cash to meet margin and collateral management calls that the new-generation higher-yield alternative products demand. Shadow banking is focused on the reuse of assets and collateral. With this comes a new set of risks for financial market policy makers to worry about: leverage, liquidity, maturity transformation, re-investment and other risks outside of traditional banking system.
The Business and Finance Outlook provides evidence on some of these trends.
Nor are global value chains that facilitate the shift in the centre of gravity of world economic activity towards emerging markets serving economic development in the manner that might be expected.
Sales-per-employee, shown by the lines in the above graph, illustrate an astounding “catch-up” of emerging countries over the past decade. However, when company “value added” per employee is calculated (shown in the bars), there is much less sign of any emerging market catch up to advanced country productivity levels, in either infrastructure or general industrial companies.
Worse still, the “value added” productivity growth apparent in the rising columns prior to the crisis has not continued in subsequent years. This is no way in which to foster promises for ageing baby boomers, nor for the stable growth of employment for younger generations. The international financial and production systems will have to be reformed towards greater competition and openness if the world economy is to be put onto a more stable path.
OECD Secretary-General Angel Gurría will present the findings in the Outlook at a launch event in Paris on 24 June 2015. This will be followed by a high-level roundtable debate on:
- risks to the financial system in a low growth and low interest rate environment
- whether pension funds and life insurers will be able to keep their promises
The event will be attended by representatives from the banking, insurance and pension fund sectors, senior pensions and insurance regulators, financial industry representatives, academics, journalists and other stakeholders.
In my view: The OECD must take charge of promoting long-term investment in developing country infrastructure
Today’s post from Sony Kapoor, Managing Director, Re-Define International Think Tank, is one in a series of ‘In my view’ pieces written by prominent authors on issues covered in the Development Co-operation Report 2014: Mobilising resources for sustainable development.
The world of investment faces two major problems.
Problem one is the scarcity – in large swathes of the developing world – of capital in general, and of money for infrastructure investments in particular. Poor infrastructure holds back development, reduces growth potential and imposes additional costs, in particular for the poor who lack access to energy, water, sanitation and transport.
Problem two is the sclerotic, even negative rate of return on listed bonds and equities in many OECD economies. The concentration of the portfolios of many long-term investors in such listed securities also exposes them to high levels of systemic – often hidden – risk.
Most long-term investors would readily buy up chunks of portfolios of infrastructure assets in non-OECD countries to benefit from the significantly higher rate of return over the long term, and to diversify their investments. At the same time, developing economies, where neither governments nor private domestic markets have the capacity and depth to fill the long-term funding gap, are hungry for such capital.
So what’s stopping these investments?
Financial risks in developing countries are well known and often assumed to be much higher than in OECD economies. Also, investing in infrastructure means that investors will find it hard to pull their money out on short notice, and therefore such investments pose liquidity risks.
Despite these easy answers, however, there are three significant caveats:
First, the events of the past few years have demonstrated that on average, political risk and policy uncertainty in developing countries as a whole have fallen, especially in the emerging economies.
Second, OECD economies are also exposed to serious risk factors, such as high levels of indebtedness and demographic decline. As the financial crisis demonstrated, they are also likely to face other “hidden” systemic risks not captured by commonly used risk models and measures.
Third, the kind of risks that dominate in developing countries, such as liquidity risks, may not be real risks for long-term investors (e.g. insurers or sovereign wealth funds). Given that the present portfolios of these investors are dominated by OECD-country investments, any new investments in the developing world may look more attractive and may actually offer a reduction of risk at the portfolio level.
So I ask again: Why aren’t long-term investors investing in developing country infrastructure in a big way?
The biggest constraint is the absence of well-diversified portfolios of infrastructure projects and the fact that no single investor has the financial or operational capacity to develop these. Direct infrastructure investment, particularly in developing countries, is a resource-intensive process.
The G20, together with the OECD and other multilateral institutions such as the World Bank, can facilitate the development of a diversified project pipeline on the one hand, together with mechanisms to ease the participation of long-term investors on the other. This work will involve challenges of co-ordination, more than commitments of scarce public funds.
In my view, the OECD – which uniquely houses financial, development, infrastructure and environmental expertise under one roof – must take charge.