Two Peas in a Pod: Thoughts on the Future Regulation of Global Food and Finance
There are two industries that have suffered recent crises of confidence – global food and global finance. In this excerpt of an article in Financial Regulation at the Crossroads, Judson Berkey investigates current challenges and similarities of these two industries.
While not immediately obvious, their stories have parallels: Both industries have moved over recent decades from mainly local and national systems to integrated global systems. They developed long supply chains where the ultimate consumer of risk is often disconnected from the originator. Finally, they are industries where de-regulation has been the trend and the assumption is that the market generally knows best.
As a result, intermediaries (namely banks but also insurers, hedge funds, pension funds, and sovereign wealth funds in the finance industry and the range of food processors, manufacturers, and retailers in the food industry) have grown in size. They are asked to be trusted sources that verify the safety, reliability, and usefulness of products. These intermediaries are often large multinationals operating across countries.
Thus, regulations must be both national and international to ensure a sustainable system. It is said that global banks are national in death. Global food chains also break down nationally as the resulting health and environmental issues must be dealt with by local authorities. The following shows some parallels in regulating the industries and suggests how the local food systems fit into the picture.
Capital and Soil
Capital for finance is like soil for food. Each provides a base from which production grows. Thus, the quantity and quality must be sufficient to deal with natural (economic and weather) cycles. While it can be supplemented for a period from external sources (governments in finance and synthetic fertilizers in food) ultimately it must be a self-sustaining system.
In the finance industry, the focus is on the quantity and quality of capital as that held by many global banks prior to the onset of the financial crisis was clearly insufficient. The general idea of taking a “risk-based” approach (i.e.tailoring the amount of capital to the nature and extent of the business activities undertaken by a bank) is not seriously at question. The goal is to re-examine the calculation mechanisms to ensure they take proper account of risks and the potential for truly unexpected (“black swan”) outcomes. Particular areas of focus are the measures of portfolio risk and the amount of capital required for activities such a securitization where, in theory, the risk is transferred from a single institution to a broader set of investors. There are also proposals for banks to retain a portion of certain exposures (i.e.“to keep some skin in the game”) to ensure they have incentives to more closely monitor risks.
In the food industry, the parallel may lie in the various regulations and other standards that help govern production processes. Examples include organic regulations and production standards such as integrated pest management or GLOBAL G.A.P. One only needs to look at debates around what “counts” as organic to see the tension between lowering norms to facilitate larger scale production and raising the bar on standards to achieve a certain outcome. Regulatory tools such as HAACP system requirements are intended to ensure a disaggregated production chain (akin to financial securitization) are controlled for health and safety.
Local food systems are well placed here as they often come with an inherent traceability due to the short supply chain. Individual producers selling directly to consumers have an enhanced sense of accountability. They know that the buck stops with them. The higher prices that consumers are often willing to pay enhance their ability to produce sustainably.
Liquidity and Centralization
The ability to centrally manage resource inflows and outflows more efficiently is a presumed benefit of scale. In the case of finance, this is the challenge of liquidity management where banks must match the claims on deposits and other liabilities with returns from their assets and other incoming revenues. A potential parallel in the food industry is the development of Concentrated Animal Feeding Operations (CAFOs) which essentially translate resource inputs (animals) into outputs (processed meat) ideally in a safe and sustainable manner.
In the finance industry, liquidity is under close scrutiny particularly as most global banks sweep funds from any number of jurisdictions and currencies into a central pool and then conduct central treasury operations to better match their funding and payment needs. This is efficient for a single institution as it allows banks to secure funds in the currency or market offering the best terms and then redeploy it where returns are best.
However, the Lehman Brothers and Icelandic bank cases made clear that this does not work well from a systems point of view where obligations are to local citizens and depositors. Ideas being considered by regulators are mechanisms that would ensure global banks hold more local assets that can be used to satisfy their local liabilities. At the extreme, there would a requirement for full local funding of all local activities. This would effectively shift the global banking model closer to something akin to a franchise model in food or a general conglomerate.
In the food industry, the parallel with CAFOs lies with the concentration of the transformation activity into a central operation. This supports a broad network where input providers often are contractors who are given specific production requirements. The outputs are distributed on a wide basis as the scale supports national or international supply chains. This presents problems because of its potential to ignore the holistic context of the value chain much as the central treasury operation of global bank ignores national needs. The challenge becomes how to regulate to ensure negative externalities (e.g.environmental damage or food safety) are limited to an appropriate degree. Forced internalization of negative externalities through payments for local effects (akin to forcing banks to hold some funds to cover local liabilities) may be one mechanism. Enhanced direct oversight of operations (akin to the regulators who sit on-site in financial institutions) may be another.
Local food systems are almost by definition not centralized. There is a very deliberate choice made to limit the scale of production, processing and distribution. This can often provide a greater ability to ensure quality, safety, and taste attributes.
It also may provide a stronger network of producers, processesors, distributors and retailers who known they depend on each other and will work together to ensure a well functioning local system.
Leverage and Waste
Many aspects of finance are decentralized in terms of the number of firms and their global market share. However, global banks are much bigger than before and in some countries such as Switzerland their balance sheets are bigger than the domestic GDP. This creates potential for contagion merely by size or interconnection as denoted by the “too big to fail” label. This is seen in the food industry as well where the WWF estimates that globally 300-500 companies control 70% of the trade in 15 major agricultural commodities.
Scale becomes an issue when combined with leverage. Leverage and the mechanisms such as short term funding used to finance that leverage have been cited as one of the primary causes of the financial crisis. One of the most dangerous aspects of financial leverage is the thin margin for error it creates (e.g.a bank on 40 to 1 leverage will have its equity wiped out with just a 2.5% loss in value of the assets financed by that capital). A somewhat similar dynamic exists in the food industry when looking at the level of food production relative to consumption.
The analogy becomes one between bank balance sheet growth and growth in food production capacity.
Estimates are that as much as 30% (and up to 50% in developed countries) of global food production is lost as waste throughout the system.
This inefficiency means that global food has been “leveraged” to produce many more calories than actually required. In essence, the food system requires extensive input use of scarce resources (land, water, energy) to produce excess food to compensate for the waste that will occur after the food is produced. Thus, the externalities (e.g.environmental damage) arising from food have been scaled beyond that which is actually required. Additionally, hunger does not decrease as it is often the wrong food in the wrong place at the wrong price. Local food systems again stand up well as they generally do not make use of extensive inputs external to the local production system and thus are better sized for their production. They are usually tailored to local diets and local historical and social contexts.
In the end, the customer decides
The shift to a globalized, industrialized economy built on scale in both food and finance has created (theoretical) efficiencies. These efficiencies have allowed economic growth (as measured by GDP with all its inherent flaws) to increase while the percentage of labor in agriculture and manufacturing decreased. However, there are no free lunches and scale came at a price that was often hidden or left to certain jurisdictions to bear. Regulators have tried to strike a balance by establishing global standards through groups such as Codex Alimentarius and the Basel Committee on Banking Supervision that allow regulators to meet to discuss the development of common regulatory norms.
The question many are asking today is whether these institutions and the regulatory norms they have developed are sufficient in light of increasingly globalized markets and the impacts of market failures. Given the apparent ease and pace with which financial markets were on a path to unravel in 2007-9, one can argue that a bit more “sand in the gears” would be a good thing.
One can see this in finance through the call for a transaction tax. In the food industry this can be seen in the precautionary approach (used to justify the EU ban on genetically modified food or importing hormone treating beef).
Policy differences and their enforcement through different regulations that restrict the amount of globalization permitted may provide useful “breathing space” for the science to become more conclusive (as intended by the precautionary principle) and for consumer values to settle (in cases where the science may be seemingly clear but consumers have certain preferences for other reasons) before truly global market shaping decisions are made. They should not be an excuse for progress however. It is a matter of defining what we mean by progress.
Thus, it is about more than just regulations and policy. If we truly want more local, sustainable, small-scale production it will require higher search costs, higher production costs, higher labor costs and ultimately a higher retail cost. It will shift the composition of employment and rearrange value chains. This is not just a technical debate. Regulations and regulators, corporations and managers, producers and suppliers are tools. The ultimate decision is made by the customer and voting citizens.
The world we live in is shaped by our individual and collective choices and what we choose to value.
* This article is an excerpt of a longer article published in Panagiotis Delimatsis & Nils Herger (eds), Financial Regulation at the Crossroads: Implications for Supervision, Institutional Design and Trade, pp.365–378.2011 Kluwer Law International BV, TheNetherlands. For the complete article contact the author at judson.berkey[at]ubs[dot]com