Integrating Socio-Economic Rights into the Regulatory Architecture of the Financial System

1. Integrating Socio-Economic Rights into the Regulatory Architecture of the Financial System Mary Dowell-Jones, Ph.D. Research Fellow Institute for Human Rights and Business

2. Overview: • Overview of the Financial Crisis • Limits of Human Rights Engagement with Finance • The Crisis – A Network of Interlocking Causal Factors • Potential for a Human Rights Response? • Moving Forward – A Strategy for Integrating ESR into the Regulatory Architecture

3. 1. Overview of Financial Crisis: • Most Critical Banking Crisis Since the Great Depression • Estimated losses of $3.4 trillion • Largest bankruptcy in history – Lehman’s $660 billion + hedge funds, insurers • Government orchestrated rescues including AIG ($177 billion), Citigroup ($326 billion), Bear Sterns, Northern Rock • Unprecedented Government bailouts – roughly $6.6 trillion across major economies • Global financial system only survived thanks to Government intervention

4. Human Rights Impacts • Major impacts of global recession on ESR: • ‘Global Jobs Crisis’ (ILO): • 21 million more unemployed in OECD • Over 600,000 a month lost jobs in USA in Q1 2009 • 20 million migrant workers unemployed in China • Thousands of jobs lost in export industries after sharp contraction in world trade post-Lehman’s • ‘An Emergency for Development’ (World Bank) • Fall in remittances/loss of migrant worker jobs • Fall in State revenue/State spending for ESCR • Rise in poverty – 53 million more people estimated to be living on less than $1.25 a day (World Bank)

5. Human Rights Impacts (cont) • Impacts in developed economies: • Rise in personal/corporate bankruptcies • Rise in foreclosures/loss of homes • Massive losses on pension funds • Rise in food insecurity (USA) • Sharp drop in government revenue/tax takes • Long term: • Explosion of government debt – likely sharp spending cuts • Impaired bank balance sheets – era of sluggish lending/growth • Threats from inflation/new asset bubbles • Health/education impacts of reduced incomes for very poor

6. 2. Limits of Human RightsEngagement with Finance • Human rights engagement has been issue-specific: • Corruption/Transparency e.g. EITI, Wolfsberg Principles • Project Finance e.g. Equator Principles • Ethical Investing e.g. UNPRI, UNEPFI • Divestment Campaigns e.g. Burma • Even Ruggie Consultation seemed limited: • Financial Companies “at least one step removed from the human rights impacts of the business activities that they enable with their funds”

7. Limits of HR Engagement: • Focus on defined areas where impacts are visible and easily mapped to financial activity e.g. project loan • Focus on familiar human rights territory where HR issues are well understood e.g. funding mining projects that impinge upon rights of indigenous people/ companies with bad labour rights • Based on prevailing ‘legal’ approaches to socio-economic rights i.e. where direct causality/responsibility is required between act/actor and victim/violation • BUT this approach does not fit the complexity and interconnectivity of 21st century finance. These initiatives do not offer a template that can be extrapolated to address the crisis. Because: • Causality is too diffuse, underlying issues too technical. • Way beyond the scope of existing approaches to ESCR

8. 3. The Crisis – A Network of Interlocking Causal Factors • Global financial system is now a huge influence on economic conditions and socio-economic rights • Hugely complex & profoundly interconnected • ‘Financialisation’ of world economic space over last 20 years: • World Stock Market cap. now $55 trillion • Daily FX trading in US alone = $660 billion up 44% in 3 years • Derivatives exposures $1000 trillion+ • In contrast – world GDP now $60 trillion • Credit Default Swaps – estimated $60 trillion in 2007

9. 3. The Crisis – Causal Factors: • Mutually Reinforcing Financial Factors: • Securitisation/explosion of credit derivatives ($1.4 trillion of US subprime mortgages) • Rise of the shadow banking system/off balance sheet vehicles • Over-reliance on credit ratings ‘outsourcing risk’ • Global search for yield • Fundamental failings of risk management • Leverage/under-capitalisation of banking system • Moral hazard + lack of understanding of dynamics of 21st century finance • System-wide abdication of responsibility

10. The Crisis – Causal Factors: • Compounded by Macroeconomic Factors: • Low interest rate environment • Arrival of China into world trading system, suppressing CPI • Build up of enormous FX reserves in Asia + their recycling into treasuries – de facto currency pegs • Huge trade deficits/surpluses – Asia produced, the West consumed • Massive build up of debt in Western economies – personal (consumption), corporate (LBOs), financial (leverage) government (war financing)

11. 4. Potential for a Human Rights Response? • There are significant underlying problems with SE rights themselves: • A legal instrument with economic foundations BUT • Has been approached as a legal project, e.g. efforts to delineate layers and typologies of obligation • Macroeconomic issues have been downplayed except as issues to argue against • Focus on economic neutrality crystalised economic decontextualisation of ICESCR • Result: No foundation of technical macroeconomic/financial content of ESCR to work from.

12. Potential HR Response? • Result: • Debate among HR lawyers has tended to focus on critique of failings of ‘neoliberalism’ • Discussions of type of State we need • Proposals to simply insert a HR clause into Basel II Capital Adequacy Accord • Lack of engagement with technical financial detail or visibility of HRs in regulatory reform debates • Limits of due diligence

13. Potential for a HR Response? • Is the Crisis a Human Rights Issue? Does it Make Financial Regulation a human rights issue? • Yes: crisis has had a devastating impact on human rights worldwide, as have previous crises. State obligations & Ruggie Framework • No: Answer isn’t so obvious. Regulatory issues are highly technical and arguably well beyond the scope of existing notions of human rights. No clear template for integration.

14. 5. Moving Forward – A Strategy for Integrating ESR into the Regulatory Architecture: • Centered on complex international accord Basel I & II • Purpose: to ensure a sound and stable financial system • Does not mandate or monitor social outcomes of market processes. Why? • Heavily quantitative/mathematical models • Probability theory/statistics • Assumes efficient, self-correcting markets.

15. Risk Management: • Fundamental to financial regulation & the way the financial markets work • Centered on probability estimates for loss distribution • Works on the assumption that by averaging market data you can predict future losses • Uses ‘normal’ market i.e. strips out tail risk • Failed abysmally to warn of crisis

16. Failings: • Highly pro-cyclical • Drove markets higher by reducing risk numbers • Strips out reference to socio-economic context • Only looks at market data, very narrow basis of analysis • Embeds complacency about actual risk • Appears highly sophisticated, but very limited picture of markets • Produced an under-capitalised financial system that was critically vulnerable to systemic problems • Compounded by fact that most financial actors were using the same regulatory-required techniques • A key lever of interconnectivity • Produces a one-way market

17. Potential for Integrating Human Rights and Risk Management • Broadening notions of risk to include ESR factors • What form could this take? • Move beyond formulaic mathematical models that do not reference market context i.e. human factors • Are inherently reductive of social processes • How? Build work that demonstrates that socio-economic rights and the goods they represent are central to value, risk and pricing. Currently largely ignored. • Return to qualitative, more contextual understanding of markets, beyond mathematical thinking

18. Build human factors into finance • E.g. Subprime mortgage boom • Over $1.4 trillion in mortgage origination between 2005-7 • Huge change in fundamentals of underlying market • Risk management methods ignored this by focusing on VaR or credit ratings – historic loss figures • No effort in banking system to look at details of what mortgages were being sold to who and whether they were affordable • Huge disconnect between social reality and financial vision • Enormous human rights consequences & enormous financial losses

19. Emerging Markets • Huge structural poverty/human rights issues ignored by financial thinking • Tendency of investors to overestimate growth prospects by ignoring institutional, legal, political, historic, social factors. Focus instead on rising stock markets/macro indicators. • Inequalities in fact often cemented by economic growth captured by elites, rather than addressing it. Econ/financial models assume the opposite. • Tendency of EM to large boom and bust cycles. • Pay more attention to the unique socio-economic, institutional & historic characteristics of each country. • Risk needs to be informed by broad assessment of HR reality. HRs benefited by better risk management.

20. Commodities • Development of commodities as an investable asset class • Huge pressure on human rights from affordability of basics like food, fuel and heating oil • No visibility of that reality in financial analysis, or of financial factors in HRs analysis – even SR on right to food focused on supply constraints and renewable fuels • But major driving factor has been use of commodity futures for investment/returns • Risk management would merely look at averaging historic price data and volatility to assess potential for loss. Would not investigate ‘structural’ reality of the human impact of prices. • Enormous pressure on HRs. No risk-based constraint.

21. Conclusion • Financial crisis has opened up debate on HR and financial system • No quick fix for failing financial system, nor for human rights • BUT risk management weaknesses offer significant opportunity • Just a starting point. Need to develop much more clarity prior to regulatory incorporation of HR standards • Workability essential

22. Institute for Human Rights and Business • www.institutehrb.org • Financial Crisis and Human Rights report: Available on website late March/April