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Complexity and Better Financial Regulation

31 August 2016
by Guest author

NAECHarald 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[1] as well as their efficiency[2]. 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.

Useful links

OECD-EC-INET Oxford Workshop on Complexity and Policy, 29-30 September, OECD HQ, Paris: Click here to register

New Approaches to Economic Challenges – Complexity of the Economy (October 2015 OECD Workshop)

OECD work on financial markets

[1] Effectiveness: Does the impact observed on the ground correspond to the outcome aimed for by the EU co-legislators?

[2] Efficiency: Is the desired regulatory outcome achieved at lowest possible compliance cost?

Complexity and Economic Policy

29 August 2016
by Guest author

NAECAlan Kirman, École des hautes études en sciences sociales Paris, and Aix Marseille University

Over the last two centuries there has been a growing acceptance of social and political liberalism as the desirable basis for societal organisation. Economic theory has tried to accommodate itself to that position and has developed increasingly sophisticated models to justify the contention that individuals left to their own devices will self organise into a socially desirable state.  However, in so doing, it has led us to a view of the economic system that is at odds with what has been happening in many other disciplines.

Although in fields such as statistical physics, ecology and social psychology it is now widely accepted that systems of interacting individuals will not have the sort of behaviour that corresponds to that of one average or typical  particle or individual, this has not had much effect on economics. Whilst those disciplines moved on to study the emergence of non-linear dynamics as a result of the complex interaction between individuals, economists relentlessly insisted on basing their analysis on that of rational optimising individuals behaving as if they were acting in isolation. Indeed, this is the basic paradigm on which modern economic theory and our standard economic models are based.. It dates from Adam Smith’s (1776) notion of the Invisible Hand which suggested that  when individuals are left, insofar as possible. to their own devices, the economy will self organise into a state which has satisfactory welfare properties.

Yet this paradigm is neither validated by empirical evidence nor does it have sound theoretical foundations. It has become an assumption. It has been the cornerstone of economic theory although the persistent arrival of major economic crises would seem to suggest that there are real problems with the analysis. Experience suggests that amnesia is prevalent among economists and that, while each crisis provokes demands for new approaches to economics, (witness the birth of George Soros’ Institute for New Economic Thinking), in the end inertia prevails and economics returns to the path that it was already following.

There has been a remarkable tendency to use a period of relative calm to declare victory over the enemy. Recall the declaration of Robert Lucas, Nobel Prize winner and President of the American Economic Association in his Presidential Address in 2003 in which he said: “The central problem of depression-prevention has been solved.”

Both economists and policy makers had been lulled into a sense of false security during this brief period of calm.

Then came 2008 and, as always in times of crisis, voices were raised, mainly by commentators and policy makers enquiring as to why economists had anticipated neither the onset nor the severity of the crisis.

When Her Majesty the Queen asked economists at the London School of Economics what had gone wrong, she received the following reply: “So in summary your majesty, the failure to foresee the timing, extent and severity of the crisis … was principally the failure of the collective imagination of many bright people to understand the risks to the systems as a whole.”

As soon as one considers the economy as a complex adaptive system in which the aggregate behaviour emerges from the interaction between its components, no simple relation between the individual participant and the aggregate can be established. Because of all the interactions and the complicated feedbacks between the actions of the individuals and the behaviour of the system there will inevitably be “unforeseen consequences” of the actions taken by individuals, firms and governments. Not only the individuals themselves but the network that links them changes over time. The evolution of such systems is intrinsically difficult to predict, and for policymakers this means that assertions such as “this measure will cause that outcome” have to be replaced with “a number of outcomes are possible and our best estimates of the probabilities of those outcomes at the current point are…”.

Consider the case of the possible impact of  Brexit on the British economy and the global economy. Revised forecasts of the growth of these economies are now being issued, but when so much depends on the conditions under which the exit is achieved, is it reasonable to make such deterministic forecasts? Given the complexity and interlocking nature of the economies, the political factors that will influence the nature of the separation and the perception and anticipation of the participants (from individuals to governments) of the consequences, how much confidence can we put in point estimates of growth over the next few years?

While some might take the complex systems approach as an admission of our incapacity to control or even influence economic outcomes, this need not be the case. Hayek once argued that there are no economic “laws” just “patterns”. The development of “big data” and the techniques for its analysis may provide us with the tools to recognise such patterns and to react to them. But these patterns arise from the interaction of individuals who are in many ways simpler than homo economicus, and it is the interaction between these relatively simple individuals who react to what is going on, rather than optimise in isolation that produces the major upheavals that characterise our systems.

Finally, in trying to stabilise such systems it is an error to focus on one variable either to control the system or to inform us about its evolution. Single variables such as the interest rate do not permit sufficient flexibility for policy actions and single performance measures such as the unemployment rate or GDP convey too little information about the state of the economy.

Useful links

OECD-EC-INET Oxford Workshop on Complexity and Policy, 29-30 September, OECD HQ, Paris: Click here to register

New Approaches to Economic Challenges – Complexity of the Economy (October 2015 OECD Workshop)

Economic outlook, analysis and forecasts at the OECD

The climate scientist and the teacher

26 August 2016
by Guest author
From Naudet, J (2000) Finding Problems to Fit the Solutions: Twenty Years of Aid to the Sahel, OECD Publishing, Paris

From Naudet, J (2000) Finding Problems to Fit the Solutions: Twenty Years of Aid to the Sahel, OECD Publishing, Paris

Laurent Bossard, Director, OECD Sahel and West Africa Club (SWAC) Secretariat

In the second of the SWAC/OECD Secretariat’s West African Papers series (“Climate Impacts in the Sahel and West Africa: The Role of Climate Science in Policy Making”), Carlo Buontempo and Kirsty Lewis of the Met Office UK consider the role climate science plays in policy making.

I had thought about calling this blog: “Don’t leave climate change policy solely to climate scientists!”. After all, the authors themselves stress that climate scientists are not necessarily fully equipped to identify what the key components of climate and climate change are in relation to a population’s needs. In the end, I resisted the temptation because I sincerely admire this profession whose daunting task it is to help us build a better future for the planet.

The question is: “how can the terabytes of data generated by the Intergovernmental Panel on Climate Change (IPCC) climate models be of use to African farmers?”. If a farmer is asked what they need, their reply will probably be for more accurate and local short-term weather forecasts to ensure that their seeds are sown at the right time. It would seem therefore that a distinction has to be made between meteorologists – who are likely to cater to the farmer’s request – and climate scientists.

The authors of this paper remind us that climate change is not just about a change in climate towards hotter, wetter, and drier conditions, but also about an increase in the variability of the climate, as well as in the number and severity of extreme events. So yes, it would be very useful to provide more accurate weather forecasts but, for all this, the need to factor in the structural dynamics associated with climate change would remain unaddressed.  Helping farmers to anticipate these dynamics and manage risk is what a “climate service” should be able to offer its African users.

Everybody seems to agree on this issue but the “how” is apparently still far from being resolved. The argument developed in this paper is that agricultural and rural communities should be listened to in order to understand how the “climate factor” fits in with their specific problems, opportunities and prospects.  The climate factor does not, therefore, replace all other issues faced by African farmers, but is an addition to them. The climate factor could thus be of central importance or less relevant, a triggering or aggravating mechanism, all depending on the context. As a result, importance should be placed upon defining the issues and asking the right questions.

I believe this message is important because it reminds us of the importance of the “human factor”. Back in 1967, a teacher named Lédéa-Bernard Ouedraogo, from Yatenga province in what is now Burkina Faso, decided to create a  “Naam group” in his village –  an adaptation of the traditional Mossi community association called Kombi-Naam, or “power to young people”. A form of agricultural and environmental cooperative, the Naam was constructed on the following five pillars which define its actions: its members, what they know, what they experience, what they know how to do and what they want. Accordingly, the Naam creates projects which are tailored to the environment, which meet the needs of its members and which are achievable. It is, in essence, a tool which promotes and develops local expertise.

The initiative has now spread throughout Yatenga province and the entire country. The National Federation of Naam Groups now comprises over 5 000 groups and over 600 000 members. Building on the Naam network, Lédéa Bernard Ouedraogo was one of the creators of the 6S Association (“Savoir se servir de la saison sèche en savane et au Sahel”) in 1976. The National Federation of Naam Groups and the 6S Association formed the basis for disseminating straightforward, effective techniques for what is now known as “climate smart” agriculture. As a result, we see that areas where climate scientists might once have said crops could no longer grow because of a lack of rain, are now using “Zaï” (30cm in diametre micro-basins scattered throughout the fields) and “boulis” (small catchments for storing water run-off).

During the 1980s when Niger’s Maradi region was severely affected by aridification, farmers had the idea of allowing trees to grow naturally in their fields. These trees help to protect against wind and soil erosion, enrich the soil with the manure of animals taking refuge in their shade, and limit temperature and evaporation, and thus effectively reduce the need for water.  According to the French Agricultural Research Centre for International Development, “assisted natural regeneration” has made it possible to regenerate hundreds of thousands of hectares of land not only in Niger but also in Burkina Faso, Mali and Chad.

The IPCC did not exist in the 1970s and early 1980s and when I read this paper, I wondered what the teacher and the climate scientist might have said to one another had they met in Yatenga. I believe that such an encounter between the science of mathematical models and the science of traditional knowledge would have been mutually beneficial and that the need to further co-ordinate efforts between disciplines, sectors and other fields of development is becoming increasingly essential.

Useful notes

OECD Work on climate change

The Global Construction Sector Needs a Big Push on Corporate Responsibility

22 August 2016

1024px-Dubai_workers_angsana_burjRoel Nieuwenkamp, Chair of the OECD Working Party on Responsible Business Conduct (@nieuwenkamp_csr)

The construction industry employs approximately 7% of the global work force and it is predicted to account for approximately 13% of GDP by 2020. The sector is a major positive force for development. However, large scale construction projects, such as those involving development of infrastructure, can come with significant impacts on local communities such as displacement and environmental damage.  Furthermore, labour rights issues are particularly salient in this sector as it relies strongly on migrant labour and workers are predominantly unskilled and earn low-wages.

Recent high profile events, such as the preparations for the 2022 World Cup in Qatar, have showcased some of the most troubling labour issues related to large scale construction projects, including forced labour, dangerous working conditions, excessive overtime, and inhuman living conditions. Particularly, the kafala system, a system of sponsorship-based employment common in the construction sector in the Gulf, has been heavily documented and criticised. Under the system, migrant labourers are sponsored by employers to come and work in Gulf countries  and their legal residency is tied to their employer, giving employer’s power over working conditions and whether worker’s can change jobs, quit jobs, or leave the country. Additionally workers often arrive in the Gulf significantly indebted due to fees paid to recruitment agencies which employ various middle men.

Certain characteristics of the construction sector make it more vulnerable to abuses. The industry is very competitive and characterised by low profit margins (about 2%); it relies heavily on sub-contracting which can go nine layers deep in certain contexts; and is subject to tight fixed deadlines, such as those related to preparation of global sporting events. It is also often under-regulated by local governments and is recognised as a high-risk sector for corruption.

The construction sector is clearly an area where there is urgent need for global initiatives to promote responsible business conduct and industry actors are feeling increasing pressure in this regard. Widely documented cases of labour abuses related to global sporting events have attracted significant public scrutiny.   For example, Human Rights Watch has carried out detailed investigations of human rights issues in the construction sector in the Gulf region. In December of last year they released a report entitled Guidelines for a Better Construction Sector in GCC, which both describes the human rights impacts associated with this sector and provides recommendations on how companies can avoid and address these risks.   Beyond reputational harms there are increasing legal consequences for construction enterprises that do not behave responsibly.  Recently for example, Sherpa, a French human rights organisation, filed a complaint against Vinci, a large French infrastructure company, in regard to their operations in Qatar and associated labour abuses.[1]

Governments are making efforts to regulate these issues through stronger reporting laws. Under the recent EU Directive on non-financial disclosure, companies incorporated in the EU or listed on EU stock exchanges must report on principle risks and due diligence processes with regard to environment, labour, human rights and corruption.  Under the UK Modern Slavery Act enacted in 2015, companies registered or operating in the UK will have to report annually on their due diligence processes to manage risks of slavery and human trafficking within their operations and supply chains.  The implementation guidance to the UK Modern Slavery Act references the OECD Guidelines for Multinational Enterprises noting that “whilst not specifically focused on modern slavery, they provide principles and standards for responsible business conduct in areas such as employment and industrial relations and human rights which may help organisations when seeking to respond to or prevent modern slavery.”

The OECD Guidelines are the multilateral agreement of 46 governments defining corporate responsibility. They form the most comprehensive set of guidelines for responsible business conduct (RBC) covering all areas of corporate responsibility, ranging from labor and human rights to environment and corruption.  The Guidelines are equipped with a unique globally active grievance mechanism, known as the National Contact Points, where parties can submit complaints regarding non-observance of the Guidelines by companies.

Under the NCP mechanism there have been 12 cases reported involving the construction sector, representing approximately 3% of all cases brought to NCPs. These cases most frequently involved impacts of large scale construction projects on local communities. For example, two cases brought to the Norwegian and Austrian NCPs, respectively, dealt with human rights impacts associated with construction of a large dam in Malaysia and Laos.  Labour issues are also a common theme. A case brought to the German NCP involving labour rights issues at Heidelberg Cement Co in Indonesia ended in a mediated agreement.  Recently a case was brought to the Swiss NCP by Building and Wood Workers’ International (BWI) regarding alleged human rights violations of migrant workers by the Fédération Internationale de Football Association (FIFA) in Qatar. According to the complaint the human rights violations of migrant workers in Qatar were widely documented in 2010 when FIFA appointed Qatar as the host state for the 2022 World Cup and FIFA failed to conduct adequate and ongoing human rights due diligence after the appointment. The case was accepted for further examination and is currently under mediation at the Swiss NCP.

Several months back the UK NCP and the Institute for Human Rights and Business (IHRB) organised a workshop on responsible business conduct in the construction sector.  My take away from the event was that it is high time for the sector to come together to address ongoing issues in this sector.  Many high-impact, high-risk sectors have engaged internationally to launch initiatives to promote responsible business conduct, including development of standards or sectoral codes of conduct. While there are some promising initiatives seeking to improve conditions in the construction sector, there is currently no global corporate responsibility effort underway.  However, given the serious risks associated with this sector as well as the amount of unskilled workers it employs globally, improving standards and performance in this sector will be crucial to advancing the Sustainable Development Goals (SDGs).

A large portion of global construction projects are publically financed. As such, government agencies and public finance institutions such as the World Bank have a significant opportunity to promote better conduct in this sector. Many governments already promote the recommendations of the Guidelines through export credit agencies, which are a significant source of global financing and insurance, specifically with regard to financing of large scale infrastructure projects in developing countries. The 2016 OECD Common Approaches for Export Credit Agencies signed on to by all OECD member countries explicitly recognise the recommendations of the Guidelines, and provide that “[m]embers should… [p]romote awareness of the [the Guidelines] among appropriate parties.” Governments could also build in criteria associated with RBC into bid evaluations for construction projects and public procurement criteria generally. Public finance institutions can build in conditionality measures associated with strong due diligence systems and standards into their financing terms.

The construction sector is a critical industry: it is crucial to sustainable development and a significant source of employment globally. However, serious impacts associated with the sector can no longer go unnoticed and mounting pressure on the industry makes this an opportune time to take significant steps internationally to address ongoing problems in the sector. However, companies cannot solve these problems on their own. Governments and public finance institutions also have a critical role to play.  Governments should push construction companies to launch or participate in global corporate responsibility efforts. They should also put their money where their mouth is and condition contracts and financing for construction projects on a demonstrated commitment to international RBC standards.

Useful links

Roel Nieuwenkamp maintains a blog where all of his articles are archived. Please visit https://friendsoftheoecdguidelines.wordpress.com/

OECD Guidelines for Multinational Enterprises

OECD CleanGovBiz initiative

[1] Vinci has responded denying the allegations and filing a defamation suit against Sherpa.

There will be no Shark Week without Sharks

19 August 2016
by Guest author

ROTMAN_N13VZweb_1Grace Hanley, OECD Environment Directorate

As an American, it’s nearly impossible to go through summer without hearing the chatter or joining in on the festivities around “Shark Week.” In case you haven’t heard of it, it’s an annual week-long television series produced by the Discovery Channel that features all sorts of action-packed shark videos. People host parties carving shark heads out of watermelons, while sporting fin hats and snacking on all sorts of marine-themed appetizers. It’s a week to celebrate and learn about these amazing creatures that have been around for over 400 million years, surviving 5 major planet extinctions. But right now, sharks are fighting against becoming the sixth major extinction, and it’s our fault.

It’s important that we expose the ugly truth about the endangerment of sharks so that we can start taking action to adequately protect them.  To start, humans are their number one predator.  This is largely attributed to overfishing—and illegally for that matter.  Humans reportedly kill 100 million sharks each year. As highlighted in “Racing Extinction,” a film that exposes the threats to shark endangerment, wildlife trade is second to the drug market in terms of profit.  This makes conservation an even greater challenge, as there are significant economic incentives for traffickers.

To make matters worse, sharks have a low reproduction rate and thus cannot recover their populations quickly or easily. For some species, such as whale sharks, maturity  is reached at the age of 30, and most are caught before they have the chance to repopulate. In extreme cases, the wait can be a century—no, that’s not an exaggeration. The Greenland shark, which was recently reported to shatter the longevity record as the longest lived vertebrate, is predicted to live for more than 400 years.  With this considered, the females becoming ready to reproduce after they turn 156 seems to prove that it really is all relative.  However, it also speaks to the challenges of reproduction, as it takes a substantial amount of time.

Over-fishing affects even deep-sea sharks, as they are targeted by the cosmetic industry for their liver oil, which has a desirable moisturizing appeal. On top of this, sharks are also exposed to threats directly caused by humans such as climate change, pollution and habitat destruction.

We should care because biodiversity matters and sharks play a key role in balancing their marine ecosystems. In fact, they have an efficient method of preying that is also beneficial to other marine life. They target the old, sick and slower fish, which helps maintain the health of other species populations.  So contrary to their Jaws-inspired portrayal of being human-threatening cold-blood killers of summer beach-goers, sharks tend to target their feedings in a strategically balanced manner. Hence, our deep fear of sharks is unfounded, as the likelihood of humans being attacked by sharks is extremely low.

We need to be realistic about our fears and the statistics that support them. Despite the fact that it is also quite unlikely, we are much more likely to be killed by fireworks than sharks. Yet, we intentionally play with fire to celebrate events such as national holidays and then act as if stepping into the ocean is a summoning for certain death.  The truth is we are much more aggressive toward sharks than they are to us and that needs to stop. With only 3% of the 500 species of sharks known to attack humans, we shouldn’t be so worried about attacks.

However, we should be worried about losing sharks because we need them. Without sharks, the marine ecosystem will lose its balance as it loses its top predator. Removing sharks will trigger a trophic cascade effect on the marine ecosystem, with the potential to permanently alter it.  The presence of sharks—and even the fear they incite, has a positive influence on ecosystems. For example, a group of scientists in Hawaii found that their presence encouraged turtles to graze over a broader area of sea grass rather than focus on the best quality of sea grass and deplete a concentrated area, which they would do had they not had the lingering threat of sharks influencing their feeding patterns.

The stability of our planet requires a balance—and unfortunately, humans tend to be at fault for disturbing that balance. Maintaining a healthy equilibrium of biodiversity is critical to the well-being of the planet and we have the power to responsibly control this, so long as we are willing to change our habits. The enthusiasm for Shark Week is a positive example of celebrating our biodiversity, but sitting down to a “delicacy” meal of shark fin soup shows we still have a long way to go. If we want to continue celebrating our biodiversity, it is important that we educate ourselves on the best ways to protect it.

The good news is, now is the perfect time to act. In 2010, the Parties to the Convention on Biological Diversity (CBD) declared 2011-2020 to be the “Decade of Biodiversity.” More importantly, the CBD set forth the concept of mainstreaming biodiversity to eliminate the idea that biodiversity and ecosystem services are separate from the goals of development and growth. In November of this year, the Parties will meet again in Mexico for COP 13 to discuss the integration of biodiversity into relevant policy sectors.

It has become increasingly evident that the biodiversity within our ecosystems is a vital component to our life and we must implement policies that not only reflect that message, but also sufficiently protect it. Moreover, ecosystems have proved to be adaptable in both positive and negative ways as species have become transient due to changes in their habitats caused by climate change, pollution, and other factors. Therefore, the importance of a global consensus that encourages the integration of biodiversity protection into legislation will be an integral part of our sustainable development as it will allow us to collectively protect our planet and shared heritage.

Useful links

OECD work on fisheries

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