81785 A World Bank Group Corporate Flagship overview 2014 world development report Risk and Opportunity Managing Risk for Development A World Bank Group Corporate Flagship 2014 world development report overview Risk and Opportunity Managing Risk for Development © 2013 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved 1 2 3 4 16 15 14 13 This work is a product of the staff of The World Bank with external contributions. Note that The World Bank does not necessarily own each component of the content included in the work. The World Bank therefore does not warrant that the use of the content contained in the work will not infringe on the rights of third parties. The risk of claims resulting from such infringement rests solely with you. 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Cover design: Heads of State Interior design: Debra Naylor Contents Foreword  v Acknowledgments  vii Overview Risk and opportunity: Risk management can be a powerful instrument for development   3 Risk is a burden but also an opportunity   4 Risk management can be a powerful instrument for development   5 What does effective risk management entail?   10 Beyond the ideal: The obstacles to risk management   16 The way forward: A holistic approach to managing risk   18 The household  21 The community  23 The enterprise sector   25 The financial system   27 The macroeconomy  31 The international community   33 An institutional reform to mainstream risk management   36 In conclusion: Five principles of public action for better risk management   40 Some closing thoughts   42 Notes  43 References  45 iii Foreword In recent years, the world has suffered a multitude of crises. Financial and economic turmoil have disrupted the world economy through loss of income, jobs, and social stability. Intense natural disasters have devastated entire communities from Haiti to Japan, leaving a trail of fatalities and economic losses in their wake. Concerns about global warming have grown, as have fears about the spread of deadly contagious diseases. As I travel around the world, I hear the same concern: how can we become more resilient to such risks? The World Development Report 2014 (WDR 2014), Risk and Opportunity—Managing Risk for Development, helps provide answers to this pressing question. Another concern is the missed development opportunities that arise when necessary risks are not taken. Pursuing opportunities requires taking risks, but many people, especially the poor, are often reluctant to do so, because they fear the potential negative consequences. Failure to act can trap people in poverty, leaving them vulnerable to negative shocks and even less able to pursue opportunities that would otherwise improve their well-being. The inability to manage risk properly leads to crises and missed opportunities. This poses significant obstacles to attaining the World Bank Group’s two main goals: ending extreme poverty by the year 2030 and boosting shared prosperity of the bottom 40 percent of the population in developing countries. Managing risk effectively is, therefore, absolutely central to the World Bank’s mission. The WDR 2014 demonstrates that effective risk management can be a powerful instrument for development—it can save lives, avert economic shocks, and help people build better, more secure futures. This report calls for individuals and institutions to move from being “crisis fighters” to becoming “proactive and systematic risk managers.” There is substantial evidence that recognizing and preparing for risk can pay off abundantly. For instance, many developing countries displayed resilience in the face of the recent global financial crisis because they had previously reformed their macroeconomic, financial, and social policies. Protecting hard-won development gains by building resilience to risk is essential to achieving prosperity. That is true whether one is grappling with natural disasters, pandemics, financial crises, a wave of crime at the community level, or the severe illness of a household’s chief provider. Risk can never be completely eliminated. But people and institutions can build resilience to risk by applying a balanced approach that includes structural policy measures, community-based prevention, insurance, education, training, and effective regulation. Countries have learned how to manage risk in diverse settings, but, until now, research related to risk management in the developing world has not been synthesized into a single source that is easily accessible and well-referenced. This WDR aims to fill that gap. It serves as a valuable guide both for mainstreaming risk management into the development agenda, and for helping countries and communities strengthen their own risk management systems. The Report also offers important insight for changing the approach to risk in the Bank’s own operations. The World Bank Group is currently undergoing a transformation, which calls for shifting the institutional culture regarding risk from one of extreme risk aversion to one of informed risk taking. This year’s WDR cautions that the greatest risk may be taking no risk at all. I could not agree more. v vi F O R E WO R D My hope is that the WDR 2014 will lead to risk management policies that allow us to minimize the danger of future crises and to seize every opportunity for development. Success on this front will help us build the world we all want: one free of poverty, with shared prosperity for all. Jim Yong Kim President The World Bank Group Acknowledgments . This Report was prepared by a team led by Norman Loayza, together with Inci Ötker-Robe. The other members of the core team were César Calderón, Stéphane Hallegatte, Rasmus Heltberg, Xubei Luo, Martin Melecky, Ana María Oviedo, and Kyla Wethli. Research analysts Sebastien Boreux, Kanako Goulding-Hotta, Rui Han, Harry Edmund Moroz, Anca Maria Podpiera, Jun Rentschler, Faiyaz Talukdar, and Tomoko Wada completed the team. Gilles Cols, Olga Jonas, Federica Ranghieri, and Anna Reva contributed to the Report’s spotlights. The Report was sponsored by the Development Economics Vice Presidency. Overall guidance for the prepara- tion of the Report was provided by Kaushik Basu, Senior Vice President and Chief Economist, and Asli Demirgüç- Kunt, Director of Research, Development Economics. The team benefited from continuous engagement with and advice from Martin Čihák, Quy-Toan Do, Mary Hallward-Driemeier, Aart Kraay, and Sergio Schmukler. An advisory panel comprising Laura Alfaro, Robert Barro, Thorsten Beck, Stefan Dercon, Ibrahim Elbadawi, Rohini Pande, Klaus Schmidt-Hebbel, Hyun Song Shin, and Jan Švejnar provided feedback and advice. The team also benefited from the advice of World Bank Chief Economists Augusto de la Torre, Shantayanan Devarajan, Marianne Fay, Ariel Fiszbein, Caroline Freund, Indermit Gill, Bert Hofman, Jeffrey Lewis, and Martín Rama. The team would like to acknowledge the generous support for the preparation of the Report by the Canadian International Development Agency, the Knowledge for Change Program, the Japan Policy and Human Resources Development Fund, and the World Bank Research Support Budget. The team also thanks the German Federal Ministry for Economic Cooperation and Development and the Deutsche Gesellschaft für Internationale Zusammenarbeit, which co-organized and hosted the WDR International Policy Workshop in Berlin, November 2012. Interagency consultations were held with the European Commission, the International Monetary Fund, the Organisation for Economic Co-operation and Development, several United Nations organizations, the World Economic Forum, and agencies for development cooperation in Denmark, Finland, France, Japan, the Netherlands, Norway, Spain, Sweden, Switzerland, and the United Kingdom. Valuable inputs were received from the World Bank Institute and all regional and anchor networks, as well as other parts of the World Bank Group, including the International Finance Corporation and the Multilateral Investment Guarantee Agency. Country consultations were held in Austria, Belgium, Brazil, Chile, Denmark, Finland, France, Germany, Indonesia, Japan, the Netherlands, Norway, Peru, Rwanda, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. Most included academics, members of civil society, and public entities and governments. Consultations with researchers and academics were aided by ad hoc conferences organized by ­ the Centre for the Study of African Economies, Oxford University, and the Center on Global Governance at the School of International and Public Affairs, Columbia University. The team also received valuable feedback at the African Economic Conference 2012, the Asia Development Forum 2013, and the Latin American and Caribbean Economic Association Conference 2012. The Report was skillfully edited by Nancy Morrison and Martha Gottron. Bruce Ross-Larson and Gerry Quinn provided additional editorial advice. The World Bank’s Publishing and Knowledge Division coordinated the design, typesetting, printing, and dissemination of the Report. Special thanks to Mary Fisk, Stephen McGroarty, Stephen Pazdan, Denise Bergeron, Andres Meneses, Shana Wagger, and Paschal Ssemaganda, as well as to the Translation and Interpretation Unit’s Bouchra Belfqih, Cecile Jannotin, and Michael Lamm. The Development Data Group contributed to the preparation of the Report’s statistical annex, coordinated by Timothy Herzog. The team also thanks Merrell Tuck-Primdahl, Vamsee Krishna Kanchi, and Swati P. Mishra for their guidance on communications strategy, and Vivian Hon for her coordinating role. Barbara Cunha, Birgit Hansl, and Manal Quota reviewed some of the foreign language translations of the Overview. The production and logistics of the Report were assisted by Brónagh Murphy, Mihaela Stangu, and Jason Victor, with contributions from Laverne Cook, Gracia Sorensen, and Tourya Tourougui. Ivar Cederholm, ­ ­ Elena vii viii AC K N OW L E D G M E N T S Chi-Lin Lee, and Jimmy Olazo coordinated resource mobilization. Irina Sergeeva and Sonia Joseph were in charge of resource management. Gytis Kanchas, Nacer Megherbi, and Jean-Pierre Djomalieu provided IT support. Background papers were provided by Joshua Aizenman, Phillip R. D. Anderson, Maximillian Ashwill, Emmanuelle Auriol, Ghassan Baliki, Thorsten Beck, Najy Benhassine, Nicholas Bloom, Julia K. Brown, Martin Brown, Daniel Buncic, Julio Cáceres-Delpiano, Sara Guerschanik Calvo, Olivier De Jonghe, Alejandro de la Fuente, Philippe de Vreyer, Mark A. Dutz, Maya Eden, Penelope D. Fidas, Roberto Foa, Rodrigo Fuentes, Garance Genicot, Gary Gereffi, Ejaz Ghani, Sudarshan Gooptu, Mikael Grinbaum, Federico H. Gutierrez, Ronald Inglehart, Susan T. Jackson, Olga B. Jonas, Jan Kellett, Ilan Kelman, Tariq Khokhar, Auguste T. Kouame, Aart Kraay, Sadaf Lakhani, Sylvie Lambert, Esperanza Lasagabaster, Ethan Ligon, Samuel Maimbo, William F. Maloney, Tom Mitchell, Ahmed Mushfiq Mobarak, Hernan J. Moscoso Boedo, Andrew Norton, Eduardo Ortiz- Juárez, Patti Petesch, Florence Pichon, Patrick Premand, Carlos Rodriguez Castelan, Natalia Salazar, Luis Servén, Francis J. Teal, Maarten van Aalst, Guillermo Vuletin, Koko Warner, Tetyana V. Zelenska, and Nong Zhu. Details of their contributions are listed at the end of the Report. For valuable contributions and advice, the team thanks Pablo Ariel Acosta, Tony Addison, Montek Ahluwalia, Ahmad Ahsan, David Aikman, Harold Alderman, Franklin Allen, Aquiles Almansi, Philippe Ambrosi, Goli Ameri, Walter J. Ammann, Dan Andrews, Paolo Avner, Edmar Bacha, Javier Baez, Hemant Baijal, Christopher Barrett, Scott Barrett, Kathleen Beegle, Tim Besley, Gordon Betcherman, Deepak Bhattasali, Indu Bhushan, Jörn Birkmann, Christiane Bögemann-Hagedorn, Uta Böllhoff, Patrick Bolton, Laura Elizabeth Boudreau, François Bourguignon, Carter Brandon, Juan José Bravo, Tilman Brück, Robin Burgess, Guillermo Calvo, Jack Campbell, Jason Cardosi, Michael R. Carter, Miguel Castilla, Michael Chaitkin, Marcos Chamon, Guang Zhe Chen, Maria Teresa Chimienti, Fredrick Christopher, Craig Churchill, Luis Abdón Cifuentes, Massimo Cirasino, Stijn Claessens, Daniel Clarke, Tito Cordella, Sarah E. Cornell, Gerardo Corrochano, Robert Cull, Julie Dana, Anis Dani, Jishnu Das, Joachim De Weerdt, Ximena Del Carpio, Jean-Jacques Dethier, Jacqueline Devine, Pierre Dubois, Patrice Dumas, Peter Ellehoj, Brooks Evans, Jessica Evans, Marcel Fafchamps, Paolo Falco, Shahrokh Fardoust, Thomas Feidieker, Wolfgang Fengler, James Fenske, Ana Margarida Fernandes, Adrián Fernández, Francisco Ferreira, Deon Filmer, Greg Fischer, James Foster, Marcel Fratzscher, Linda Freiner, Roberta Gatti, Francis Ghesquiere, Swati Ghosh, Antonino Giuffrida, David Gleicher, Markus Goldstein, George Graham, Margaret Grosh, Patricia Grossi, Mario Guadamillas, Conor Healy, Frank Heemskerk, Joachim Heidebrecht, Jesko Hentschel, Rafael Hernández, Matt Hobson, John Hoddinott, Niels Holm-Nielsen, Naomi Hossain, Andrew Hughes Hallett, Oh-Seok Hyun, Elena Ianchovichina, Ridzuan Ismail, Takatoshi Ito, Abhas K. Jha, Emmanuel Jimenez, Steen Jørgensen, Nidhi Kalra, Sujit Kapadia, Masayuki Karasawa, Corneille Karekezi, Supreet Kaur, Lauren Kelly, Igor Kheyfets, Beth King, Naohiro Kitano, Leora Klapper, Alzbeta Klein, Kalpana Kochhar, Kiyoshi Kodera, Friederike Koehler-Geib, Diane Koester, Robert Kopech, Anirudh Krishna, Jolanta Kryspin-Watson, Howard Kunreuther, Kiyoshi Kurokawa, Christoph Kurowski, Miguel Laric, Alexia Latortue, Sara Lazzaroni, Nick Lea, Daniel Lederman, Margaret Leighton, Robert Lempert, Sebastian Levine, Yue Li, Irina Likhacheva Sokolowski, Justin Yifu Lin, Kathy Lindert, Gladys Lopez, Augusto López Claros, Leonardo Lucchetti, Maria Ana Lugo, Olivier Mahul, Thomas Markussen, Will Martin, María Soledad Martínez Pería, Eric Maskin, Laura Mazal, J. Allister McGregor, Claire McGuire, Robin Mearns, Carlo Menon, Rekha Menon, Erwann Michel-Kerjan, Tim Midgley, Gary Milante, Suguru Miyazaki, Nuno Mota Pinto, Marialisa Motta, Joy Muller, Akira Murata, Lydia Ndirangu, Ha Nguyen, Giuseppe Nicoletti, Yosuke Nishii, Michel Noel, Alistair Nolan, Sharyn O’Halloran, Philip O’Keefe, Ory Okolloh, Michelle Ooi, Miguel Angel Ostos, Marcus C. Oxley, Robert Palacios, Pepi Patrón, Douglas Pearce, Brian Pinto, Russell Pittman, Jean-Philippe Platteau, Sandra Poncet, David Popp, Antonin Pottier, Prashant, John Primrose, Hnin Hnin Pyne, Ricardo Raineri, Anthony Randle, Martin Ravallion, Robert Reid, Ricardo Reis, Ortwin Renn, Changyong Rhee, Helena Ribe, Michelle Riboud, Jamele Rigolini, Dena Ringold, David Robalino, Jorge Luis Rodriguez Meza, Rafael Rofman, Jonathan Rothschild, Davinder Sandhu, Apurva Sanghi, Hans-Otto Sano, Yasuyuki Sawada, Stefano Scarpetta, Anita Schwarz, Paul Seabright, Junko Sekine, Amartya Sen, Rodrigo Serrano-Berthet, Shigeo Shimizu, Paul B. Siegel, Joana Silva, Emmanuel Skoufias, Marc Smitz, Irina Solyanik, Joseph Stiglitz, Adrian Stone, Stéphane Straub, Henriette Strothmann, Pablo Suarez, Kalanidhi Subbarao, Mark Sundberg, Olumide Taiwo, Tamanna Talukder, Kazushige Taniguchi, Finn Tarp, Gaiv Tata, Maria Hermínia Tavares de Almeida, Stoyan Tenev, Mehrnaz Teymourian, Erik Thorbecke, Klaus Tilmes, Carlos Tortola, Izabela Toth, Carolina Trivelli Ávila, Yvonne Tsikata, María Cristina Uehara, Tunc Tahsin Uyanik, Renos Vakis, Dominique Van De Walle, Ashutosh Varshney, Adrien Vogt-Schilb, Eiji Wakamatsu, Sophie Walker, Simon Walley, Christine Wallich, David Waskow, Masato Watanabe, Asbjorn H. Wee, Jonathan B. Wiener, Alys Willman, Lixin Colin Xu, Mohamed Mahdi Youssouf, and Asta Zviniene. The team also thanks the many others inside and outside the World Bank who provided comments. OVERVIEW Risk and opportunity Risk management can be a powerful instrument for development 2 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 Managing risk for a life full of opportunities: a mother protects her child against malaria with a bed net in Ghana. FPO © Arne Hoel/World Bank OVERVIEW Risk and opportunity Risk management can be a powerful instrument for development The past 25 years have witnessed un­ conducting it effectively, and how can precedented changes around the these obstacles be overcome? The WDR world—many of them for the bet- 2014’s value added resides in its em- ter. Across the continents, many phasis on managing risks in a pro- countries have embarked on a active, systematic, and integrated path of international integra- way. These characteristics under- tion, economic reform, techno- score the importance of forward- logical modernization, and dem- looking planning and preparation ocratic participation. Although in a context of uncertainty. They challenges and inequalities remain, also highlight the necessity to address economies that had been stagnant for all relevant risks jointly, using all avail- decades are growing, people whose families able tools and institutions. From a policy had suffered deprivation for generations are escaping maker’s perspective, a proactive, systematic, and in- poverty, and hundreds of millions are enjoying the tegrated approach to managing risks involves strik- benefits of improved living standards and scientific ing a proper balance between the contribution from and cultural sharing across nations. As the world the state and the contribution from individuals, civil changes, a host of opportunities arise constantly. With society, and the private sector, with the goal of en­ them, however, appear old and new risks, from the suring that these contri­ butions are coordinated and possibility of job loss and disease to the potential for complementary. social unrest and environmental damage. If ignored, The WDR 2014 argues that risk management can these risks can turn into crises that reverse hard-won be a powerful instrument for development—not gains and endanger the social and economic reforms only by building people’s resilience and thus reducing that produced these gains. The solution is not to re- the effects of adverse events but also by allowing them ject change in order to avoid risk but to prepare for to take advantage of opportunities for improvement. the opportunities and risks that change entails. Man- The WDR 2014 is not devoted to a detailed analysis aging risks responsibly and effectively has the poten- of specific risks. Its framework, however, can be im- tial to bring about security and a means of progress plemented to address particular, relevant sets of risks for people in developing countries and beyond. in given regions and countries. Focusing on the pro- The World Development Report (WDR) 2014 cess of risk management allows the WDR 2014 to focuses on the process of risk management, address- consider the synergies, trade-offs, and priorities in- ing these questions: why is risk management impor- volved in addressing different risks in different con- tant for development, how should it be conducted, texts, with the single motivation of boosting develop- what obstacles prevent people and societies from ment (box 1). 3 4 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 B ox 1   Five key insights on the process of risk management from the World Development Report 2014 1. Taking on risks is necessary to pursue opportunities 4. For risks beyond the means of individuals to handle for development. The risk of inaction may well be the alone, risk management requires shared action and worst option of all. responsibility at different levels of society, from the 2. To confront risk successfully, it is essential to shift from household to the international community. unplanned and ad hoc responses when crises occur to 5. Governments have a critical role in managing sys- proactive, systematic, and integrated risk management. temic risks, providing an enabling environment for 3. Identifying risks is not enough: the trade-offs and shared action and responsibility, and channeling obstacles to risk management must also be identi- direct support to vulnerable people. fied, prioritized, and addressed through private and public action. Source: WDR 2014 team. Risk is a burden but also an opportunity sumption by almost 10 percent and continued to be negatively affected three to five years later.1 Health Why worry about risk? In recent years, a multitude costs from high levels of crime and violence amount of crises have disrupted the world economy and to 0.3–5.0 percent of gross domestic product (GDP) have had substantial negative consequences on de- a year for countries in Latin America, without even velopment. Because of the 2008–09 global financial considering the impact of crime on lost output crisis, most economies around the world experi- stemming from reduced investment and labor par- enced sharp declines in growth rates, with ensuing ticipation.2 Loss of employment in countries as dif- loss of income and employment and setbacks in ef- ferent as Argentina, Bulgaria, and Guyana not only forts to reduce poverty. When food prices spiked in has lowered income and consumption but has also 2008, riots broke out in more than a dozen countries reduced people’s ability to find new work, worsened in Africa and Asia, reflecting people’s discontent and social cohesion, and in some cases increased domes- insecurity and causing widespread political un- tic violence.3 rest. The 2004 Asian tsunami, the 2010 earthquake Whether adverse consequences come from sys- in Haiti, and the 2011 multiple hazard disaster in temic or idiosyncratic risks, they may destroy lives, northeastern Japan—to name but a few—have left assets, trust, and social stability. And it is often the a trail of fatalities and economic losses that exem- poor who are hit the hardest. Despite impressive plify the increased frequency and intensity of natu- progress in reducing poverty in the past three de- ral disasters. Concerns about the impact of climate cades, a substantial proportion of people in devel- change worldwide are growing, and so are fears oping countries remain poor and are vulnerable to about the spreading of deadly contagious diseases falling into deeper poverty when they are struck by across borders. Indeed, the major economic crises negative shocks (figure 1). The mortality rate from and disasters that have occurred in recent years and illness and injury for adults under age 60 is two and those that may occur in the future underscore how a half times higher for men and four times higher vulnerable people, communities, and countries are for women in low-income countries than in high- to systemic risks, especially in developing nations. income countries, while the rate for children under Idiosyncratic risks, which are specific to individu- age five is almost twenty times higher.4 Mount- als or households, are no less important for people’s ing ­evidence shows that adverse shocks—above all, welfare. Losing a job or not finding one because of health and weather shocks and economic crises— inadequate skills, falling victim to disease or crime, play a major role in pushing households below the or suffering a family breakup from financial strain or poverty line and keeping them there.5 Moreover, forced migration can be overwhelming, particularly realizing that a negative shock can push them into for vulnerable families and individuals. Households destitution, bankruptcy, or crisis, poor people may in Ethiopia whose members experienced serious stick with technologies and livelihoods that appear illness, for example, were forced to cut their con- relatively safe but are also stagnant. Risk and opportunity 5 F I G U R E 1   Many people around the world are poor or live very close to poverty; they are vulnerable to falling deeper into poverty when they are hit by negative shocks More than 20 percent of the population in developing countries live on less than $1.25 a day, more than 50 percent on less than $2.50, and nearly 75 percent on less than $4.00. a. All developing countries, 2010 b. Developing countries by region, 2010 500 $1.25 per day 16 $1.25 per day 14 % of population in each region $2.50 per day $2.50 per day Total population, millions 400 12 300 10 8 200 6 4 100 2 0 0 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14 US dollars US dollars Sub-Saharan Africa Middle East and North Africa South Asia Latin America and the Caribbean East Asia and Paci c Europe and Central Asia Source: WDR 2014 team based on data from World Bank PovcalNet (database). Note: $1.25 per day is a widely used measure of extreme poverty. However, $2.50 per day is considered a more relevant measure of extreme poverty for some regions, such as Latin America and the Caribbean. See Ferreira and others 2013. Yes, confronting risk, as the possibility of loss, is Risk management can be a powerful a burden—but it is also necessary to the pursuit of instrument for development opportunity. Risk and opportunity go hand in hand in most decisions and actions taken by countries, Whether risks are systemic or idiosyncratic, imposed enterprises, and families as they seek to improve or taken on voluntarily, development can occur only their fate. Indeed, risk taking is intrinsic to the pro- by successfully confronting risk and pursuing op- cess of development. Consider a few examples. Since portunity. Many crises and development losses are the 1990s, most developing countries have opened the result of mismanaged risks. No less important, their borders to seek international integration and many opportunities are missed because preparation higher economic growth, but in the process they for risk is insufficient and necessary risks are not have also increased their exposure to international taken—the “risk of inaction.” It is therefore essential shocks. Firms around the world have made invest- to shift from unplanned and ad hoc responses when ments to upgrade their technologies and increase crises occur to proactive, systematic, and integrated ­ profitability, but the debt required to do so has risk management. As such, risk management can made them more vulnerable to changes in demand build the capacity to reduce the losses and improve and credit conditions. From Brazil to South Africa, the benefits that people may experience while con- millions of families have migrated to cities to seek ducting their lives and pursuing development op- better job opportunities and health and education portunities (drawing 1 and profile 1). services, where they have also become more exposed Risk management can save lives. Consider the to higher crime and benefit less from communal case of Bangladesh, where improved preparation for support. The motivation behind these actions is natural hazards has dramatically reduced loss of life the quest for improvement, but risk arises because from cyclones. In the past four decades, three major favorable outcomes are seldom guaranteed. cyclones of similar magnitude have hit Bangladesh. 6 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 D r aw i n g 1  Risk management for everyone: A visual representation of key concepts To pursue opportunity, people must …not one risk, but many confront risk Job Job loss Disease Loss Opportunity Risk Crime Natural Natural Disasters disasters Financial Financial crises Crises ...and often burdened with obstacles risk burdened ...and often Sharing with with others canobstacles overcome to manage them to manage these them obstacles Job Disease Disease Job Job Community Family loss Loss Loss Natural Natural Natural Disasters disasters Disasters Crime Crime Banks Financial Financial Enterprises Financial crises Crises Crises Int‛l Int‛l Government community Community ...through collective action and institutions Risk management can be a powerful tool for development Knowledge Protection Insurance Coping Drawing by Jason Victor for the WDR 2014. Risk and opportunity 7 P r o fi l e 1   The Gomez family: A modern tale of risk and resilience The Gomez family lives in a shantytown on the from school. Having two income earners (and a outskirts of Lima. Only a few years ago, the fam- willing grandmother) made the Gomez house- ily lived in a rural village in the Peruvian Andes, hold more resilient to whatever might happen. where they had a small farm. The region was And things did happen. Mario, the eldest prone to droughts, and they could never earn son, was injured in a traffic accident. There was enough income to escape poverty. Many of no car insurance, and the family had to bear the their neighbors had migrated to the city in the cost of Mario’s medical treatment. They could not 1980s, pushed by civil conflict in the countryside. have done it alone, and they didn’t have to. They The Gomez family refused to go for fear of los- relied on a public hospital, run and financed by ing their land and finding nothing better in the the state. Medical treatment there was of uneven city. The risk was too large. Peru was a different quality, but it provided basic services. The fam- place then: inflation and unemployment were ily had to spend some of their limited savings to rampant, and the threat of social unrest was ever supplement the hospital services and buy medi- ­ present. cation, but all that was worth it because Mario In the 1990s, the macroeconomy was stabi- recovered. lized and the civil war ended. New opportunities The Gomezes had to dig into their assets once started to arise in urban and rural areas. At first, again, but this time for a very different purpose. these opportunities eluded the Gomez family. A Elena—the second daughter, whom everyone dam had been constructed near their village, but regarded as the brains in the family—came using its waters required the renovation of canals home one day and asked her parents if she could on their farm. They applied for a loan from a com- study English in the evenings. This was a good mercial bank but were denied, which came as no idea. Peru had recently signed several free trade surprise since it was their first time applying. Mr. agreements (one of them with the United States), and Mrs. Gomez came to believe that their chil- and exporting companies had started to grow, dren had no future in the village and decided to offering jobs to young, qualified people. English migrate to the city. This time, however, they did would be a big plus. not have to worry about losing their farm. They Some months before, however, her parents had been given a property title and were able to would have declined her initiative on the grounds sell the farm to a neighbor, who had the capital that it was not safe to be out at night. Police pro- to renew the canals. The money from the farm tection was scarce in the outskirts of the city, and would give the Gomezes a cushion as they took criminals took advantage of that. When a crime the momentous challenge of migration. wave eventually affected the Gomezes’ shanty- Lima, with just under 10 million inhabitants, town, the community put together neigh­ bor­ seemed like a huge and inhospitable place. That hood patrols (effective, although at times unduly is why they decided to move to the shantytown harsh). When Elena asked for English classes, the where many members of their village had relo- safety risk had been reduced, and she could go cated. There, they would find companionship, out to study in the evenings. As time passed, she cultural identity (all the festivals of their old and her family would be well prepared to benefit village were properly celebrated here), and, of from the period of stability and sustained growth course, help finding a job. Mr. Gomez found work that Peru was experiencing. on a construction site, but it was irregular, with Confronting risks and seizing opportunities frequent layoffs. Mrs. Gomez had to pitch in, and may have put the Gomez family on the path out she was fortunate to find work as a seamstress in of poverty, possibly forever. It was their work, ini- a textile enterprise. The grandmother helped out, tiative, and responsibility that made it possible, taking care of the children when they returned but they could not have done it alone. Source: WDR 2014 team. Note: A video of this fictional story is available in nine languages on the World Development Report 2014 website http://www.worldbank .org/wdr2014. 8 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 FIGURE 2  The benefits of risk management often outweigh the costs 12 10 Bene t-cost ratios 8 6 4 2 Break- even point 0 Vaccinations Improved Early warning Nutritional Measures to reduce damage from: water and systems interventions Earthquakes Floods Tropical storms sanitation Source: Wethli 2013 for the WDR 2014. Note: The figure shows the median of benefit-cost ratios across a range of studies in each category (with a minimum of at least four esti- mates in each category). Above the dotted line, expected benefits exceed expected costs. The range of estimates within each category can be substantial, reflecting a diversity of intervention types and locations, and the sensitivity of estimates to variations in underlying assumptions. However, in almost all cases, even the 25th percentile of the ranges are above the break-even point. A cyclone in 1970 claimed over 300,000 lives, but to undertake new promising ventures. Some farmers one in 1991 claimed almost 140,000, and one in 2007 in Ethiopia, for instance, choose not to use fertilizer claimed about 4,000. Casualties have been greatly because they fear drought and other potential shocks reduced by a nationwide program to build shel- and thus prefer to retain savings as a cushion rather ters—from only 12 shelters in 1970 to over 2,500 in than investing in intermediate inputs.8 In contrast, 2007—along with improved forecasting capacity and farmers in Ghana and India have been more willing a relatively simple but effective system for warning to take on risk in search of higher yields—increas- the population.6 ing their investments in fertilizer, seeds, pesticides, Risk management can avert damages and prevent and other inputs—because they have rainfall insur- development setbacks. Countries as different as the ance.9 When aggregated, these gains can have much Czech Republic, Kenya, and Peru offer recent com- broader effects, contributing to improved productiv- pelling examples where macroeconomic preparation ity and growth for a country as a whole. has shielded the economy from the negative effects Crises and losses from mismanaged risks are of a global financial crisis. Having achieved lower fis- costly, but so are the measures required to better cal deficits, disciplined monetary policy, and lower ­ prepare for risks. So, does preparation pay off? Ben- current account deficits, these countries experienced efit-cost analyses across a number of areas suggest a smaller decline in growth rates in the aftermath of that risk preparation is often beneficial in averting the 2008 international crisis than they did following costs, sometimes overwhelmingly so (figure 2). There the 1997 East Asian crisis. The same beneficial ef- seems to be a lot of truth in the old adage that “an fect of macroeconomic preparation seems to have ounce of prevention is worth a pound of cure.” For occurred in many other low- and middle-income example, a regimen of mineral supplements designed countries.7 to reduce malnutrition and its related health risks Risk management can unleash opportunity. Risk may yield benefits at least 15 times greater than the management tools—such as improved information, cost of the program.10 Similarly, improving weather crop insurance, and employment diversification— forecasting and public communication systems to can help people mitigate risk. The ability to mitigate provide earlier warning of natural disasters in devel- risk, in turn, can allow people, especially the poor, to oping countries could yield estimated benefits 4 to 36 overcome their aversion to risk and be more willing times greater than the cost.11 Risk and opportunity 9 B ox 2   A risky world: Trends in risk across regions The risks that people face have changed considerably over time, every region of the world. While Latin America, the Middle East and although this evolution has sometimes varied across regions. Risks North Africa, and Sub-Saharan Africa all have suffered significantly have eased in some areas—such as maternal health, where the mor- fewer years of recession in each decade since the 1980s, Organisa- tality rate has declined in all regions. Conversely the incidence of tion for Economic Co-operation and Development (OECD) countries crime has increased substantially in Latin America and Sub-Saharan have experienced more. Africa. Strikingly, the incidence of natural disasters has increased in a. Maternal mortality b. Homicides 800 25 Rate per 100,000 live births 1990 1981–1990 Rate per 100,000 people, 700 2000 20 1991–2000 600 annual average 2010 2001–2010 500 15 400 300 10 200 5 100 0 0 OECD EAP ECA LAC MENA SAR SSA OECD EAP ECA LAC MENA SAR SSA c. Incidence of natural disastersa d. Large recessionsb 4.5 0.4 4.0 1981–1990 1981–1990 1991–2000 1991–2000 Proportion of decade 3.5 0.3 2001–2010 2001–2010 Annual average 3.0 in recession 2.5 0.2 2.0 1.5 1.0 0.1 0.5 0 0 OECD EAP ECA LAC MENA SAR SSA OECD EAP ECA LAC MENA SAR SSA Source: WDR 2014 team based on data from World Bank World Development Indicators (database); EM-DAT OFDA/CRED International Disaster Database; United Nations Office on Drugs and Crime Homicide Statistics (database). Note: Figures show the simple average across countries in each region. OECD countries in the figure are high-income countries that have been members of the OECD for at least 40 years. All other countries are grouped into geographic regions. EAP = East Asia and Pacific; ECA = Europe and Central Asia; LAC = Latin America and the Caribbean; MENA = Middle East and North Africa; SAR = South Asia; SSA = Sub-Saharan Africa. a. Natural disasters include droughts, earthquakes, floods, and tropical storms. b. Large recessions are identified by following Barro and Ursúa 2012 and using as a threshold a 5 percent decline in GDP per capita growth from peak to trough. There were no large recessions in South Asia from 1991 to 2010. Comparing the cost-effectiveness of preparing is both unavoidable and necessary. For instance, a for risk with that of coping with its consequences family living in a violence-ridden community faces is one of the important trade-offs that must be as- safety, health, and property risks and must choose sessed. The choice between these actions depends how to allocate its limited budget to protect and in part on how the (certain) costs of preparing for insure against each of these risks. Likewise, a small risk compare to the (often uncertain) benefits of country prone to torrential rains and also exposed doing so.12 In addition, risk management requires to international financial shocks must decide how considering different risks and the relative need of much to spend in flood prevention infrastructure preparing for each of them (box 2). Given limited and how much to save to counteract the effects of resources, setting priorities and making choices financial volatility. 10 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 When risks are taken on voluntarily in the pursuit prices their products will command in the market. of opportunity, another trade-off emerges: expected And governments decide the level of policy interest returns must be weighed against the potential losses rates and fiscal deficits in the presence of uncertain of a course of action. This trade-off is intensified external conditions, domestic productivity growth, when a higher return is possible only if more risk is and changes in financial markets. accepted. That is often the case with financial invest- ments, where a lower yield is characteristic of a more The analysis of choice under uncertainty in secure position, and higher yields with riskier posi- economics and public policy tions.13 A risk-return trade-off may also be perceived for certain development actions: for instance, public It is only natural, therefore, that the analysis of choice opinion and certain experts may link the pursuit of under uncertainty and scarce resources has been at higher economic growth with lower environmental the heart of economics and public policy for cen- protection or higher inequality.14 Although this and turies. The basic approach to decision under un- other risk-return trade-offs may not be present, risk certainty—introduced by Daniel Bernoulli in the management entails addressing them as a legitimate 1700s and modeled formally by John von Neumann possibility. and Oskar Morgenstern in 1944—is based on the Risk management involves not only considering notion that individuals optimize the expected “util- trade-offs but also taking synergies into account. ity” (or subjective perception of welfare) of possible These can make both preparation for and conse- outcomes.18 This expected utility approach relies on quences of risk less costly. They can also diminish individuals making rational choices, based on their risks and increase expected benefits. These “win- preferences for risk and their knowledge of potential win” situations are widespread and should be em- outcomes and respective probabilities. phasized—which is not to say that they are costless Notwithstanding its valuable insights, this ap- or always easy to implement. Investments in nutri- proach has been challenged on two important tion and preventive health, for example, make people grounds. The first is that individuals do not seem to more productive while reducing their vulnerability operate in a fully rational manner, possibly because to disease.15 Similarly, improvements in the busi- uncertainty makes the decision process so com- ness environment, such as streamlining regulations plicated that people prefer simple behavioral rules and improving access to credit, can induce the en- that evolve over time but are not always optimal. terprise sector to become more dynamic and grow The work of Maurice Allais in the 1950s and Daniel more quickly, while also making it more resilient to Kahneman and Amos Tversky in the 1970s focused negative shocks.16 At the macroeconomic level, dis- attention on the limitations and innate tendencies of ciplined monetary and fiscal policies—reflected in human behavior when confronting decisions under moderate inflation and sustainable public deficits— uncertainty.19 accelerate economic growth while reducing high vol- The second challenge to the basic expected utility atility in the face of external and domestic shocks.17 approach is that individuals do not make decisions in isolation but in groups, mainly because the poten- What does effective risk management tial outcomes can be greatly affected by how people act in coordination with others. The work of Duncan entail? Black in the 1940s and James Buchanan and Mancur As the ancient Greek philosopher Heraclitus wrote, Olson in the 1960s emphasized the shortcomings of the only thing constant is change. And with change and obstacles to collective action.20 Although origi- comes uncertainty. Faced with choices for bettering nally concerned with the state’s provision of public their lives, people make virtually every decision in the goods, the public choice approach extends to actions presence of uncertainty. Young people decide what to taken by any group, from households to communi- study or train for without knowing exactly what jobs ties of any size. The basic insight is how valuable and and wages will be available when they enter the labor at the same time elusive it is to coordinate collective market. Adults decide how much and how to save for action, especially in the face of uncertainty. retirement in the face of uncertain future income and A different strand of the economics literature is investment returns, health conditions, and life spans. also concerned with the collective action problem Farmers decide what to cultivate and what inputs to and offers critical principles to overcome them. use not knowing with certainty whether there will be In their pioneering work in the 1960s and 1970s, enough rain for their crops and what demand and Leonid Hurwicz, Roger Myerson, and Eric Maskin Risk and opportunity 11 studied the problem of mechanism design to may be positive (such as abundant rainfall or a wind- achieve efficiency in markets, organizations, and fall in terms of trade) or negative (illness or war). institutions. The critical insight here is that incen- They may affect small groups (such as a family or a tive constraints should be considered as important rural community) or large ones (a region or a coun- as resource constraints in understanding decision try). And they may occur suddenly (such as natu- making in the presence of uncertainty.21 This in- ral hazards or financial shocks) or gradually (such sight is vital when developing the best ways to coor- as demographic transitions, technological trends, dinate the collective action of any group, especially or environmental changes). Whether the outcomes under asymmetric information, diverging interests, from those shocks are positive or negative, large or and limited knowledge. It forces analysts and policy small, individualized or widespread, depends on the makers to see beyond aggregate resources and ques- interaction between shocks and the internal and ex- tion what informs and motivates the actions of peo- ternal conditions that characterize a social and eco- ple and organizations, including actions related to nomic system (such as a household, a community, managing risk. or a country). Importantly, the effect of shocks on people’s outcomes is also mediated by their actions to prepare for and confront risk. An analytical framework for risk management This interaction can be represented by a risk The insights derived from the economics of decision chain (diagram 1), which can be applied to different under uncertainty provide an analytical framework types of risks and contexts.22 For example, whether for risk management. The World Development Report someone becomes ill during a pandemic depends 2014 proposes that this framework consists of several on how contagious the virus is (the initial shock); interrelated steps: population density and living conditions in given areas (the external environment or exposure); peo- Assessing the fundamental goals of and motiva- •   ple’s individual susceptibility (internal conditions, tions for risk management: that is, resilience in the such as their age or the strength of their immune face of adverse events and prosperity through the system); and the steps they take to prevent becom- pursuit of opportunities (discussed in the first two ing sick or contaminating others, such as frequently sections above). washing their hands or wearing a face mask (risk •   Understanding the environment in which risks management). Similarly, whether an enterprise can and opportunities take place (referred to below as successfully take advantage of new technology and the risk chain). innovation depends on the characteristics of the technology (the initial shock); the infrastructure in Considering what risk management entails: that •   the country, which may affect the enterprise’s access is, preparing for and coping with both adverse and to the technology (the external environment); how positive events (presented below under “The com- innovative the enterprise is (internal conditions); ponents of risk management”). and how much capital the enterprise has accumu- •   Assessing the main obstacles that individuals and lated and how informed it is about the benefits and societies face in managing risk, including con- potential drawbacks of the new technology (risk straints on resources, information, and incentives management). (discussed below in the section entitled “Beyond In this context, risk is defined as the possibility of the ideal”). loss. Risk is not all bad, however, because taking risks is necessary to pursue opportunity. Opportunity is Introducing the potential role of groups and col- •   defined as the possibility of gain, thus representing lective action at different levels of society to over- the upside of risk. People’s exposure to risk is deter- come the obstacles that people encounter in man- mined by their external environment. For example, aging risk (presented below in the section “The whether a house is exposed to the risk of coastal way forward”). flooding depends on its location. Vulnerability occurs when people are especially susceptible to losses from negative shocks because of a combination of large Understanding the environment in which risks exposure, weak internal conditions, and deficient and opportunities arise: The risk chain risk management. For example, a highly leveraged The world is constantly changing and generating financial institution that has taken very risky posi- shocks that affect individuals and societies. Shocks tions without counterbalancing hedges is vulner­ able 12 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 8 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 The risk chain: The nature and extent of outcomes depend on shocks, D i agr a m 1   exposure, internal conditions, and risk management External environment Risk ks Shocks management anagement Outcomes Internal conditions Source: WDR 2014 team. Note: The feedback arrows in the risk chain diagram represent the potential for the outcomes of past shocks to affect exposure and internal conditions, as well as the propensity for future shocks. Similarly, the effectiveness of people’s risk management can significantly ­ affect the nature of and propensity for future shocks. to an economic or financial shock. Likewise, a poor The components of risk management: household with few assets and volatile income may Preparation and coping be especially vulnerable to increased food prices. To achieve that goal, risk management needs to Risk management is the process of confronting combine the capacity to prepare for risk with the risks, preparing for them, and coping with their ef- ability to cope afterward—taking into account how fects. Resilience is characterized by the ability of peo- the up-front cost of preparation compares with its ple, societies, and countries to recover from negative probable benefit. Building on the seminal contribu- shocks, while retaining or improving their ability to tion from Isaac Ehrlich and Gary Becker, prepara- function. Much of the emerging literature on risk in tion should include a combination of three actions a development context emphasizes the important that can be taken in advance: gaining knowledge, role that risk management can play in increasing acquiring protection, and obtaining insurance.23 resilience to negative shocks. However, to increase Once a risk (or an opportunity) materializes, people prosperity and well-being, risk management also take action to deal with what has occurred through has an essential role in helping people and countries coping (diagram 2). A strong risk management strat- successfully manage positive shocks. Indeed, success- egy would include all four of these components: fully managing positive shocks is a critical part of knowledge, protection, insurance, and coping. They increasing people’s resilience to negative shocks over interact with each other, potentially improving each time. For example, a farmer’s ability to withstand a other’s quality. For instance, better knowledge can drought may be substantially influenced by how the lead to more efficient decisions regarding the alloca- yields from years of good rainfall were managed. tion of resources between insurance and protection. Thus the goal of risk management is to both decrease Likewise, better insurance and protection can make the losses and increase the benefits that people expe- coping less difficult and costly. Several obstacles, rience when they face and take on risk. however, often make this risk management strat- Risk and opportunity 13 D i agr a m 2   The interlinked components of risk management Insurance To transfer resources across people and over time, from good to bad states of nature Knowledge To understand shocks, internal and Coping external conditions, and potential To recover from losses and outcomes, thus reducing uncertainty make the most of benefits Protection To reduce the probability and size of losses and increase those of benefits Preparation Coping Source: WDR 2014 team. egy difficult to achieve in practice, as is discussed in While knowledge of risks often has been lacking more detail below. in developing countries, it is increasing in several key areas, such as dealing with disease, economic Knowledge cycles, and natural hazards. And new technologies Obtaining knowledge and thus reducing the un- are greatly helping to improve knowledge of poten- certainties that people face when they confront risk tial shocks and inform responses to them. Farmers in and pursue opportunities is the first component of Ghana and 15 other African countries, for example, risk management. Knowledge entails more than just receive specific market information through their amassing information: while obtaining information mobile phones, which helps them improve their about possible events and their likelihoods is neces- response to changes in agricultural prices and de- sary, knowledge also involves using that informa- mand.24 Globalization and scientific advances have tion to assess exposure to those events and possible also improved understanding of many pathogens, outcomes and then deciding how to act. Knowledge including how they can be detected and diagnosed therefore contains elements of assessment and judg- rapidly to enable disease control. Improved tech- ment. Furthermore, people’s knowledge of risk de- nologies have also supported greater collaboration pends not only on the information they can access among scientists and policy makers, as well as en- but also on the quality of information that is pro- abling the media to inform people, even in remote vided by other social and economic systems. Indeed, parts of the world. public policy has an important role to play in im- proving the availability, transparency, and reliability Protection of information that may be relevant for risk prepara- Protection includes any actions that lower the prob- tion, including national account and labor statistics, ability and size of negative outcomes or increase the various market signals, and weather forecasts, among probability and size of positive outcomes. Develop- others. Moreover, the state can contribute by reduc- ing countries have made substantial improvements ing the uncertainty that can be created by erratic in some aspects of their risk protection in recent de- policies, protracted implementation of reforms, and cades. The percentage of people in low- and middle- frequent regulatory changes. income countries with access to improved sanitation, 14 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 for instance, increased from 36 percent in 1990 to 56 formal insurance. For example, new devices for cars percent in 2010; meanwhile, the immunization rate can allow insurers to vary the insurance premiums for measles doubled from 41 percent to 83 percent they charge based on the quality of people’s driving.28 between 1985 and 2010.25 Improved sanitation and Together, knowledge, insurance, and protection increased vaccinations, alongside other preventive constitute preparation. The assets of households, health measures, have helped reduce infant and ma- communities and governments, as well as services ternal mortality rates. Similarly, following repeated provided by markets and the public sector, all influ- cycles of high inflation during the 1970s and 1980s, ence preparation for risk, which in turn affects out- many developing countries established sound fiscal comes. Overall, the extent of people’s preparation and monetary policy frameworks, which have helped for risk tends to be correlated with national income reduce the intensity and incidence of large recessions across countries. However, interesting variations (see box 2). Increased use of early warning systems within regions highlight the important role of policy has helped to protect populations exposed to natural in determining preparation for risk, over and above hazards, reducing fatalities when major events occur. access to resources (box 3). Insurance Coping To the extent that protection cannot completely The final component of risk management is coping, eliminate the possibility of negative outcomes, insur- which encompasses all actions that are taken once a ance can help cushion the blow from adverse shocks. risk (or, alternatively, an opportunity) has materi- Insurance includes any instruments that transfer alized. Coping, therefore, consists of deploying the resources across people or over time, from good to knowledge, protection, and insurance resources that bad states of nature. In certain cases, insurance for have been obtained during the preparation phase. particular risks is provided by specialized markets The relationship between coping and preparation in the financial system. However, because formal becomes very fluid when confronting an evolving insurance markets are often not widely available in risk. This includes updating relevant knowledge by developing countries, a larger burden is placed on monitoring and assessing emerging risks and then self-insurance, which is often pursued through rela- adapting and implementing any necessary and avail- tively costly and inefficient means, such as holding able responses. durable assets (like jewelry) that can be sold in the The choice of how much to prepare for risk has event of a shock. Large numbers of households also implications for the kind of coping that is needed, participate in informal, community-based risk shar- which, in turn, can contribute to vicious or virtuous ing, and microfinance and microinsurance programs circles in risk management. When effective prepara- are increasingly providing new instruments that help tion limits the damages from adverse shocks, coping people manage risk. Similarly, alongside traditional can be minimal—leaving more resources available safety nets, conditional cash transfers and other so- for further investments in risk management, reduc- cial insurance programs are a means for the state to ing vulnerability to future shocks, and so on. At the transfer resources to help the most vulnerable cope household level, for instance, having health insurance with adverse circumstances.26 can facilitate medical treatment and recovery, while There may be either synergies or trade-offs be- reducing out-of-pocket expenses, when a family tween insurance and protection as strategies to man- member falls ill or suffers an accident. At the mac- age risk. To the extent that having insurance reduces roeconomic level, evidence suggests that by reducing people’s incentives to prevent bad states from occur- losses from natural hazards, for example, preparation ring, insurance and protection act as substitutes for for risk may sustain and even accelerate economic each other. However, when the steps that people take growth.29 to attain protection facilitate or make it cheaper to In contrast, when preparation is limited or a insure against adverse outcomes, protection and in- shock is unexpectedly large, coping can be haphazard surance can complement each other.27 Being a non- and require costly measures—leaving few resources smoker, for instance, can make it easier and cheaper available for future risk management, worsening to obtain health insurance. Protection often must vulnerability to shocks, and weakening households’ be observable for insurance and protection to be ability to undertake new opportunities. For example, complements. While observability is already highly the loss of assets that occurs from natural disasters relevant for informal risk sharing in communities, in countries as different as Ethiopia and Hondu- technology may also make it increasingly relevant for ras—caused by direct damage from a hurricane or Risk and opportunity 15 B ox 3   How does preparation for risk vary across countries? Index of risk preparation across countries Least prepared quintile Most prepared quintile Missing data People’s preparation for risk at the country level includes actions by sanitation facilities, and an indicator of fiscal space based on gross and contributions from all social and economic groups and institu- public debt as a percentage of revenues (state support).a tions, including the state. An index of preparation for risk is charted This index shows that the extent of people’s preparation for risk on the map above. The index, developed for the World Development tends to be correlated with national income across countries, but Report 2014, comprises measures of assets and services across four only to a certain extent. People tend to be the most prepared in important categories—human capital, physical and financial assets, high-income countries (particularly in North America and western social support, and state support—that influence preparation for Europe), and least prepared in low-income countries (especially in risk. The component indicators for the index include: average years Africa), on average. However, substantial variation exists within of total schooling for the population aged 15 and over, and the regions. For example, Chile is reasonably well prepared for risk, immunization rate for measles (human capital); the proportion of while its neighbor to the east, Argentina, has only average risk prep- households with less than $1,000 in net assets, and an index of access aration despite having a similar level of income per capita. Likewise, to finance (physical and financial assets); the percent of the work- Ethiopia has better risk preparation than other countries in the force who contribute to a pension scheme, and the proportion of region with similar or relatively higher income per capita. This respondents stating that “in general, people can be trusted” (social underscores the importance of policies, over and above income support); and the percent of the population with access to improved level and access to resources, in determining preparation for risk. Source: Foa 2013 for the WDR 2014. Map number: IBRD 40097. a. Each indicator is rescaled to range between zero and one. The index, which is the average of the eight indicators, thus maintains the cardinal properties of the indicators, rather than simply being an average of rankings across the components. This approach follows in part the methodology used in the construction of the Worldwide Governance Indicators (see Kaufmann, Kraay, and Mastruzzi 2010). If necessary, each indicator is transformed so that an increase in its measure represents an improvement. drought, lack of insurance, and distressed sale of world in the midst of the 2008–09 crisis—including assets—has substantial short-term as well as long- bailouts of large financial firms, fiscal stimulus, and term effects: poor households can effectively become extended periods of monetary easing—helped calm trapped in poverty, making them more vulnerable markets in the short-run, these responses may have to future negative shocks and less able to undertake negative longer-term effects, including substantially new ventures for improvement.30 Similarly, while increased public debt and perverse incentives for fi- the coping responses by governments around the nancial institutions’ risk taking. 16 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 Beyond the ideal: The obstacles to risk this information. Cognitive shortcomings are rel- management evant and pervasive obstacles to risk management in many circumstances, even in advanced countries. In If risk management can save lives, avert economic the United States, for example, a survey revealed that damages, and unleash opportunity—and, further- only 31 percent of homeowners in flood-prone areas more, if risk management is cost-effective and its were aware of the risk.31 The repercussions of extreme fundamentals are well understood—then, why aren’t instances of lack of information and knowledge— people and societies better at managing risk? Al- so-called “deep” uncertainty—are explored below. though the specific answer varies from case to case, it is always related to the obstacles and constraints Behavioral failures. Even if information exists, deci- facing individuals and societies, including lack of sion makers may be unable to turn knowledge into resources and information, cognitive and behav- actions and behaviors that prepare them for risk. In ioral failures, missing markets and public goods, and many cases, decision and policy makers seem to have social and economic externalities. This realization short memories regarding the origins of crises of leads to an important message. Identifying risks is various sorts. Systemic financial crises, for instance, not enough: the obstacles to risk management must are almost always preceded by unusually high credit also be identified, prioritized, and addressed through concentration and growth, and this process seems private and public action (box 4). to be well understood.32 Yet policy makers often do Consider the case of Mumbai. Its drainage system little to control credit booms. A false sense of security is more than 100 years old and barely capable of han- may underlie people’s inability to manage prepara- dling the annual monsoon rains. Reports and pro- tion for risk in normal times (by saving for a rainy posals have repeatedly spelled out how investments, day or completing disaster preparedness plans, for such as installing pumping stations and clearing instance). And a “paradox of protection” can arise: out debris, are needed to expand the capacity of the risk protection that suppresses losses for a long pe- storm drainage system. Yet with few exceptions, the riod creates a false sense of security, leading to de- proposals have not been acted upon. An exceptionally creased vigilance and risk awareness and potentially large monsoon hit the city in 2005, leading to more resulting in larger future losses.33 In many cases what than 400 deaths, extensive damage to buildings and might be perceived as irrational behavior may in fact infrastructure, and interruption of economic and fi- be the result of distorted incentives, incorrect or in- nancial activity. Afterward, a fact-finding committee sufficient knowledge, or particular social norms and made recommendations for overhauling the drainage cultural beliefs. system that were distressingly similar to those made in the 1990s. As of 2013, however, implementation is again lagging. As a result, India’s financial capital re- Obstacles beyond the control of individuals mains highly vulnerable to monsoon rains. hamper their risk management Missing markets and public goods. Markets in areas critical for effective risk management—credit, insur- Why aren’t people better at managing their ance, jobs—are weak or even missing in many de- own risk? veloping countries. So are public goods and services Lack of resources. Even when a risk management essential for risk management—economic and polit- strategy is cost-effective, individuals and groups may ical stability, law and order, and basic infrastructure. find it difficult to undertake because of large up- In fact, well-developed markets may be missing be- front costs and limited access to credit. Shortages of cause supportive public goods are flawed. If, for in- assets and finance, which are especially acute in poor stance, the justice system does not enforce contracts, and developing countries, can make the trade-offs it makes little sense to buy health, vehicular, or house inherent in risk management harder to handle. Gov- insurance, and no such market will exist.34 There are ernments may decide that, given their limited bud- many reasons why public goods are missing, but this get, current consumption spending is more pressing discussion considers only the most pertinent ones for than investments for disaster risk reduction. risk management. The first, already discussed, is lack of resources: the costly flood protections constructed Lack of information and cognitive failures. Relevant in the Netherlands, for example, are simply not fea- information may not exist or be available to decision sible for many similarly threatened developing coun- makers, or they may lack the ability to understand tries, like Bangladesh or Vietnam. The second reason Risk and opportunity 17 B ox 4   Bringing the essentials of and obstacles to risk management together in policy design Designing effective public policy must go beyond simply identify- ing—helping to identify critical gaps and revealing effective, low- ing potential risks to analyzing obstacles to risk management. cost interventions. Diagram a below presents a set of screens to assist in decision mak- a.  A set of screens to aid risk management Risk Information Behavior Resource Policy Incentive assessment assessment assessment assessment assessment design How Are bad incentives leading to too Are Are cognitive Are What policies much risk much or too little risk taking? decision- and behavior resources should be are we makers ill biases impairing and access implemented? Because of Because of facing? informed? risk to resources market failures? government management? too limited? failures? This practical approach provides two important insights for the should aim for robust policies that may not be optimal in the most design of risk management policies: likely future, but that lead to acceptable outcomes in a large range of scenarios and that are easy to revise as new information becomes Be realistic. Simple risk management instruments should be pre- available. Starting with a strong foundation for risk management ferred when capacity is low. Policy makers should concentrate on requires a long-term perspective, creates the right incentives, and low-hanging fruit and win-win solutions. Soft measures that change minimizes the risk of unintended negative effects. It also helps incentives (such as improving zoning regulations for coastal areas) ensure that policies are flexible enough to be adjusted when new are preferable as a starting point to engineered measures (such information becomes available. (For more on both these insights, as dikes to prevent flooding). Furthermore, it is particularly cost- see the discussion entitled “Five principles of public action for bet- effective to strengthen the capabilities that are useful in managing ter risk management” at the end of this overview.) risks of different natures, such as the ability to complete large-scale evacuations (which can be useful for either a hurricane or a nuclear Thinking about both the fundamental components of and accident, for example). Realistic policy options should ensure that obstacles to risk management with these lessons in mind can help risk management avoids unintended negative policy consequences; identify which specific policies are most relevant in different con- provides the right incentives to build on everybody’s best capaci- texts. For example, countries with limited resources or weak institu- ties; and protects the most vulnerable, who are often least able to tional capacity should focus on policies that are foundational, while implement ideal but expensive solutions. countries that already have solid foundations for risk management in place can aim for more advanced policies. This framework is used Build a strong foundation for improved risk management over time. It throughout the World Development Report 2014 to organize and pri- often makes sense to create institutional arrangements when the oritize risk management policies across the four main components need for them is obvious, such as after a disaster event, and that of risk management (knowledge, protection, insurance, and coping) cannot be easily reversed once the memory of the event has disap- for different social and economic systems, from the household to peared. This institutional irreversibility should be combined with the international community. These are summarized in correspond- flexible implementation and continuous learning. Policy makers ing tables for each of these systems (diagram b). b.  A framework for public policy priorities Policies to support risk management Foundational Advanced Knowledge Protection Insurance Coping Source: WDR 2014 team. 18 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 is related to the political economy of risk manage- rest of the world. Both negative and positive exter- ment. Governments may be reluctant to spend on nalities may complicate the process of risk manage- risk preparation because its costs are immediate and ment, making it less predictable and distorting its in- observable while its benefits, even if substantial, are centives. The solution is coordination and collective longer term and less visible. action, which can be difficult to obtain when there are wide differences in preferences, values, and expo- Government failures. Risk management can also be sures. For instance, externalities and collective action impaired by government failures stemming from failures may be why reaching a binding international capture by interest groups, corruption of govern- agreement on greenhouse gas emissions is proving ment officials, and distortionary policies. On policy so elusive. capture, enterprises and people who are negatively affected by certain risk management measures will Deep uncertainty and robust solutions naturally tend to oppose them and be vocal about it, while the people protected by these measures are “Deep uncertainty” is an obstacle to risk manage- often not aware of them (and therefore do not sup- ment that deserves special attention. Also known as port them), or lack the commensurate influence of Knightian uncertainty in economic circles,37 deep active lobbies. Powerful tobacco and asbestos lob- uncertainty refers to a situation for which even ex- bies, for instance, can block useful health regulations perts cannot agree on appropriate models to under- even in the presence of well-established scientific stand it, on the potential outcomes and probabilities evidence. On distortionary policies, sometimes even of its occurrence, and on how much importance well-intentioned measures can impair risk manage- should be given to it. Taking a broad perspective, the ment by distorting people’s incentives to manage difference between deep uncertainty and ordinary their own risk. An example is poorly designed post- uncertainty is a matter of degree, fluid, and evolv- disaster support that creates moral hazard and dis- ing. Building knowledge helps to reduce the degree courages risk management by individuals and firms. of uncertainty. The history of science is full of cases Similarly, overly generous safety nets or financial where deep uncertainty gradually became ordinary sector bailouts can undermine incentives for risk uncertainty, amenable to management and control. preparation. But while this happens, what should be done in the presence of “unknown unknowns”? Social and economic externalities. Risk management Under conditions of deep uncertainty, it is pref- actions undertaken by some people or countries erable to implement adaptive and robust policies may impose losses on others. For instance, overuse and actions that lead to acceptable outcomes in of antibiotics is creating ever more drug-resistant a large range of scenarios and that can be revised bacteria. Similarly, excessive exploitation of common when new information is available and when the natural resources such as oceans, forests, and the at- context changes.38 For monetary and financial mosphere—a phenomenon known in the literature policy, a promising practice is the use of stress test- as “the tragedy of the commons”—is leading to en- ing of banks and other financial institutions using vironmental degradation, climate change, and a fu- a broad range of situations, including forward- ture drop in economic growth.35 In a different realm, looking crisis scenarios.39 Above all, plans that are an expansion in the money supply to stimulate the designed for the most likely outcomes but that in- domestic economy in large advanced economies is crease the vulnerability to less likely events should creating destabilizing capital inflows to developing be avoided. For instance, dike systems built only for countries, as well as eroding the wealth of domestic standard rainstorms and tides can actually increase savers and taxpayers. Similarly, instituting trade bar- vulnerability by creating a false sense of security riers to protect domestic producers during economic and dramatically increasing the damages when a downturns imposes increased cost on trade partners flood does occur. and can lead to trade retaliation, possibly turning a downturn into a protracted world recession.36 Other The way forward: A holistic approach to risk management actions can generate benefits for managing risk people other than those bearing their cost, therefore creating incentives to “free ride.” That is the case, for Can individuals on their own overcome the obstacles instance, for countries that take costly measures to to risk management they face? Although individuals’ reduce greenhouse emissions, which can benefit the own efforts, initiative, and responsibility are essen- Risk and opportunity 19 tial for managing risk, their success will be limited without a supportive external environment. While Key social and economic systems can di agr a m 3  individuals on their own may be capable of dealing contribute to risk management in complementary ways with many risks, they are inherently ill-equipped to confront large shocks (such as the head of a house- hold falling ill), systemic shocks (such as a natural People’s risk management hazard or an international financial crisis), or mul- tiple shocks that occur either simultaneously or sequentially (for example, a drought followed by a food price shock and food insecurity). The state Civil society and the People can successfully confront risks that are be- private sector Social protection yond their means by sharing their risk management • Health, old age, and Households unemployment with others. They can pool their risk collectively • Family ties insurance through various overlapping social and economic • Assistance and relief Communities groupings (systems). Indeed, the need to manage risk Public goods • Collective action • Infrastructure and pursue opportunity collectively may often be a • Law and order Enterprise sector key reason why these groups or systems form in the • National defense • Jobs and income first place.40 These systems extend in size and com- Public policy Financial system plexity—from the household to the international • Macroeconomic • Insurance and credit management community. They have the potential to support • Regulatory framework people’s risk management in different yet comple- mentary ways (diagram 3). Their different scope may allow them to handle shocks and exposures that match their scale (box 5). International community • Resources, expertise, global rules, and coordination The household is the primary instance of support, •   pooling resources, protecting its members—espe- Source: WDR 2014 team. cially the vulnerable—and allowing them to invest in their future. Communities provide informal networks of insur- •   ance and protection, helping people deal with id- The international community can offer expertise, •   iosyncratic risks and pooling resources to confront facilitate international policy coordination, and common risks. pool resources when risks exceed national capac- ity or cross national and generational boundaries. Enterprises can help absorb shocks and exploit •   the opportunity side of risk, contributing to more These systems have mutual interactions, often stable employment, growing income, and greater complementing and sometimes substituting for each innovation and productivity. other’s risk management functions. For instance, various mechanisms of protection and insurance The financial system can facilitate useful risk man- •   provided by communities, enterprises, the financial agement tools such as savings, insurance, and system, and the state can complement and improve credit, while managing its own risks responsibly. households’ self-protection and self-insurance. En- terprises rely on macroeconomic stability, public The state has the scale and tools to manage sys- •   services, and financial products to remain dynamic temic risks at the national and regional levels, to and continue to provide income and employment provide an enabling environment for the other to people. The financial system can provide tools of systems to function, and to provide direct support insurance, saving, and credit only if enough house- to vulnerable people. These roles can be achieved holds and enterprises are able to participate in the through the provision of social protection (social system, and if the economy features a certain degree insurance and assistance), public goods (national of stability and predictability. Markets, in general, defense, infrastructure, law and order), and public can provide risk management tools and resources at policy (sound regulation, economic management). a growing scale if the necessary public services, such 20 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 B ox 5   Which systems for which risks? Individuals face a multitude of risks, and various social and economic job loss of the head of the household or a burned-down house). The systems can help them manage risks that are beyond their means state must sometimes provide substitutes for these functions when alone. But which systems are most appropriate for which risks? Two markets are missing or not available to some. important principles provide a way to prioritize risk management Because systemic risks affect large groups of people, they can across systems: hardly be managed by individuals alone. Communities have an advantage in managing small systemic risks (such as local violence 1. The principle of subsidiarity suggests that risks should be handled or flooding) because of their proximity to the groups of people at the lowest level capable of handling them, to take advantage affected and their potential advantage in monitoring and resolving of the proximity to and greater knowledge of the agents most local tensions. The state also has an advantage in managing small directly affected by a risk, as well as the ability to monitor both systemic risks (such as moderate fluctuations in aggregate prices those agents and the risks that they face. or regional food shortages) because of its capacity to control the 2. The principle of comparative advantage suggests that risks should national macroeconomy and transfer resources between different be managed by the system that can handle them most effectively. parts of a country. Individuals and households are well placed to handle idiosyn- Because many agents within a country are severely affected cratic risks (such as minor injuries or income shortfalls) as long as the when large systemic shocks occur, such as economy-wide banking potential losses remain relatively small. They have an advantage in crises or natural disasters, the cross-support they can provide for managing these types of risk because of their proximity to the level one another is limited. In other words, it is difficult for the private at which the main impact occurs and because of their ability to sector alone to pool and insure for systemic risk. The state thus has a monitor conditions and efforts within the household. unique role in managing large systemic risks because it has the scale As the size of potential losses increases, the tools that individuals and tools to prepare at the national and regional levels. Support and have at their disposal can quickly be exhausted. The enterprise and coordination from the international community is needed when financial systems can thus provide effective tools and mechanisms large systemic risks cross national borders or overwhelm national (discussed in more detail in the sections below) for individuals to capacities. Spotlights in the WDR 2014 feature case studies of risk manage potential losses from large idiosyncratic shocks (such as the management by different support systems. Types of risk that can be managed by different systems and examples featured in the WDR 2014 spotlights Small Large idiosyncratic idiosyncratic risk risk Small systemic risk Large systemic risk System best placed to Individuals and The enterprise sector The community and The state and the manage risk households and financial system the state international community Health risks (Turkey and the Kyrgyz Food shortages Natural hazards (the Republic) (Ethiopia and El Philippines and Colombia) Spotlight examples Loss of employment and income (India) Salvador) Financial crises (the Czech Urban violence (Brazil Republic, Peru, and Kenya ) and South Africa) Pandemics (global) Source: WDR 2014 team. as the rule of law and a sound regulatory framework, more prevalent and the relative roles of the house- are in place and effective. The international commu- hold and the community are larger. For these coun- nity relies in part on responsible governments that tries, the international community may also play a are willing to cooperate to address global risks; in larger role through financial assistance and capac- turn, the international community can help govern- ity building. As countries advance—and informal ments and countries that lack resources and capacity mechanisms give way to formal ones—the relative for risk management. importance of the contributions from the enterprise The relative importance of these systems changes sector and the financial system grow. The potential with the level of development. In less advanced role of the state is larger in less developed countries, countries, and especially in fragile and conflict-af- but in these cases the state tends to suffer from more fected countries, informal mechanisms tend to be severe capacity and resource constraints. These limi- Risk and opportunity 21 tations call for a mutual, symbiotic relationship be- tional support to confront risk and pursue opportu- tween the state, civil society, the private sector, and nity. Extending Gary Becker’s metaphor in A Treatise the international community, as countries develop on the Family, households are “little factories” where (see below). goods and services of knowledge, protection, and insurance are produced, using both “intermediate inputs” obtained from the rest of society and the The state, civil society, and the private sector: pooled efforts and skills provided by family mem- Helping one another manage risk bers.43 How can the household contribute? None of the social and economic systems presented above works perfectly. Indeed, in certain cases they Protection and risk pooling for its members. Protection hinder rather than help people’s risk management. and insurance at the household level are particularly They have the potential, however, to become effective important for idiosyncratic risks and even more rele- support systems when their weaknesses are resolved. vant when market or social insurance is lacking. Pro- The state thus has an important potential role to play tection against adverse shocks is especially important by complementing and supporting the functions for the vulnerable within the household: the young, that households, communities, enterprises, and the the old, and the ill. For this purpose, families can financial system may serve. From this perspective, benefit from the resources that are available in soci- the state’s role goes beyond the narrow purpose of ety—all the more so if these resources are increasing correcting market failures and extends to address- and improving. Thus, for instance, higher incomes ing systemic risks, building institutions that enhance and better access to health services have increased each component of risk management, and providing immunization rates for measles to more than 70 direct support to vulnerable populations. percent in every region of the world, although Sub- It would be naïve, however, to ignore the fact that Saharan Africa still has much room for improvement the state often falls short in fulfilling its potential role. (figure 3a). Historically and throughout the world, examples of Moreover, sharing bad times (and good times) government failures are regrettably abundant.41 This occurs naturally in the household. Indeed, pooling is all too vividly evident in the case of fragile and risk within and across family generations has been conflict-affected countries. What to do then? Civil a basic form of insurance from time immemorial. society, the private sector, and the international com- The extended family plays an active role, especially munity can provide badly needed public goods and in developing countries. For instance, evidence from services—albeit imperfectly. Especially, but not only, Bangladesh, Ethiopia, India, Mali, and Mexico shows in democratic societies, they can also help improve that extended family members step in to help out in governance and the delivery of public services by a substantial way when their relatives fall ill.44 Simi- generating mechanisms to make the state responsive larly, evidence from several countries around the to the needs of the population and accountable for world indicates that family members who migrate its actions.42 assist their families through remittances when nega- The discussion that follows assesses the poten- tive shocks occur in their place of origin.45 tial contribution of each major system and suggests ways to improve their performance, individually and Allowing its members, especially the young ones, to in combination with other systems. The state’s po- make investments for the future. The role of house- tential contribution is presented in connection with holds extends well beyond protecting and insuring each system, reflecting its overarching role and al- members against negative events. Households invest lowing for an elaboration of specific recommenda- in the human capital and social skills of their mem- tions for public policy, as well as a discussion of their bers, especially the young, preparing future genera- rationale and trade-offs. tions to manage the risks and opportunities they will face. Schooling is one important example where progress has occurred in recent decades. The aver- The household age number of years of educational attainment has How can it foster resilience and prosperity? increased since 1960 in all regions—most substan- tially in regions that initially had the lowest attain- For most people, the household—defined as a group ment (figure 3b). However, the quality of education, of individuals related to one another by family ties— as measured by international exams in science, math, constitutes the main source of material and emo- and reading skills, is still lagging behind in many 22 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 FIGURE 3 Education and health outcomes in developing countries are improving, but unevenly a.  Measles immunization rate b.  Educational attainment of 15–24 year-olds 100 10 % of children aged 12–23 months 9 90 8 Years of education 80 7 6 70 5 4 60 3 50 2 1990 1995 2000 2005 2010 1960 1970 1980 1990 2000 2010 OECD East Asia and Paci c Europe and Central Asia Latin America and the Caribbean Middle East and North Africa South Asia Sub-Saharan Africa Source: WDR 2014 team based on data from World Bank World Development Indicators (database) (panel a) and Barro and Lee 2010 (panel b). Note: Organisation for Economic Co-operation and Development (OECD) countries in the figure are high-income countries that have been members of the OECD for at least 40 years. All other countries are grouped into geographic regions. low- and middle-income countries, without signs of health insurance, significantly reduces the incidence converging yet.46 of catastrophic medical expenditures, especially for poor households.47 Given the fundamental impor- tance of health for everything else people do, there What characteristics improve the household’s is indeed great need for health insurance and much contribution to risk management? room for improvement: only 17 percent of adults in Households are small but complex units. The moti- developing countries report having contributed to vations of their members can range from altruism to health insurance, and this share is as low as 2 percent self-interest, the intrahousehold relationships can be in some low-income countries.48 based on common goals or relative bargaining power, and the household’s connections to society can be Fairness within the household. One would like to fluid or remote. These characteristics can have great think of households as nurturing, cohesive units. influence on how well the household functions as a All too often, however, abuse and discrimination first line of support to confront risk and opportunity. occur within the family, making it a source of, rather than a solution to, risk. Compelling evidence shows Access and participation. Communities, labor and fi- that women’s economic and social empowerment nancial markets, and public institutions provide the can strongly influence whether the allocation of re- “intermediate inputs” that families build upon to sources within the household benefits children and manage their risks. Continuous access to and par- promotes gender equality.49 An evaluation of a cash ticipation in those markets and institutions is critical transfer program in South Africa, for instance, found for families to be successful risk managers (so much that pensions received by women improved the so in the view of the World Development Report 2014 health and nutritional status of girls but that trans- that the following four sections are devoted to as- fers received by men had no effect on either boys or sessing how they can contribute). To give just one girls.50 One important ingredient for women’s eco- example: evidence from 59 countries suggests that nomic empowerment is access to the labor market, access to programs that limit out-of-pocket health which in several contexts is limited by inadequate expenditures, such as social insurance and private child care infrastructure and restrictive social norms. Risk and opportunity 23 Some countries and regions have much room for tolerate violence or discrimination against women improvement: female labor participation rates are and children. The campaigns should target both only 20–30 percent in the Middle East, North Africa, men and women: more than 20 percent of women in and South Asia, while in most of the rest of the world all regions, except Latin America and the Caribbean, they are well above 50 percent.51 believe a husband is justified in hitting or beating his wife for reasons like going out without telling him and arguing with him.56 How can the state contribute? The state has an important role to play in providing social services and countering harmful social norms. The community Policies that empower households as a unit and poli- How can the community foster resilience and cies that empower individuals within households are prosperity? necessary. Communities are groups of people who interact Providing essential social services. Access to good, frequently and share location or identity. Neighbor- even if basic, educational and medical services hood groups, religious groups, and kinship groups can prepare people to confront major health risks, are some examples. They work through informal handle life-cycle transitions, and take advantage networks based on trust, reciprocity, and social of work opportunities. In this sense, the drive for norms—what James Coleman and Robert Putnam “equality of opportunities” can also bring about re- call “social capital.”57 In this way, communities can silience for households and individuals.52 The efforts help their members by sharing idiosyncratic risks of Thailand and Turkey to offer universal access to and confronting common risks and opportunities. quality health insurance deserve special mention. Universal access to health care is likely to require a Sharing idiosyncratic risks. Informal insurance is partnership between the public and private sectors particularly important for low-income households to ensure both fiscal sustainability and sufficient and is sometimes their only real safety net. In the vil- human resources.53 For the most vulnerable, targeted lage of Nyakatoke in Tanzania, for instance, with a safety nets can have a dramatic impact in preventing population of only 120 families, there are about 40 the coping responses that incur long-term costs— different insurance schemes (burial societies, rotat- such as reducing basic consumption, withdrawing ing savings associations, and arrangements to share children from school, selling productive assets in dis- labor and livestock).58 These practices are also rele- tress sales, or resorting to crime. Ethiopia’s Produc- vant at the country level. Indonesian households, for tive Safety Net Program is one successful example of instance, have informal insurance against 38 percent protecting the most vulnerable from food insecurity of the economic costs of serious health shocks and 71 while building community assets to better manage percent of the costs of minor illness.59 In Nigeria, in- climatic risks and raise productivity.54 formal credit and assistance make up 32 percent of all coping responses identified by households (figure 4). Increasing women’s power in the household. This can be done first through economic empowerment: en- Confronting common risks and opportunities. When couraging women’s participation in the labor force communities channel their social capital for collective and, for poor households, directly increasing their action, they can provide some publics goods (such as purchasing power. An example of the latter is con- basic transport and irrigation infrastructure) to pro- ditional cash transfer programs that make payments tect against common adverse events (such as epidem- to women directly; impact evaluations have shown ics, natural hazards, and crime and violence) and to that these programs improve family and, especially, facilitate taking advantage of common opportunities children’s outcomes, including health and cogni- (such as new markets and technologies).60 This col- tive development.55 A second route is through social lective action can be especially important when state and legal empowerment: enforcing legal measures capacity is low. The informal settlement of Orangi in against abuse and domestic violence, eliminating Karachi, Pakistan, for example, financed and orga- regulations that discriminate against women in asset nized its own sanitation, vaccination, microfinance, ownership or economic activity, and conducting family planning, and violence prevention, assisted by educational campaigns to counter social norms that a local nongovernmental organization. 24 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 FIGURE 4  People respond to shocks on their own and by pooling risk with others Malawi Uganda Tajikistan Uzbekistan Afghanistan Iraq Maldives Sudan Nigeria 0 20 40 60 80 100 % of all coping responses when faced with a shock Informal credit and assistance Formal credit and assistance Consumption reduction Savings and sale of assets Employment or migration Source: WDR 2014 team based on data from household surveys, various years 2004–11. What characteristics improve the How can the state contribute? community’s contribution to risk Reliance on personal interactions and informal management? means of enforcement underlies the strength of Cohesiveness. Communities with strong ties between communities, but it is also the source of their weak- their members—that is, those communities endowed ness. Communities struggle with systemic risk and with high “bonding” social capital—are better able to falter when risk management requires complex and organize collective action on behalf of the group.61 In long-term preparation. Governments can help by fact, for local problems whose solution eludes mar- providing essential public goods and promoting in- kets and governments, a cohesive community can be clusion and respect for diversity. the missing piece of the puzzle. Cohesiveness is not easy to achieve, however, when community members Providing essential public goods, such as infrastructure have different values and cultural identities, as is in- and rule of law. Communities’ autonomous coping creasingly the case in urban communities. Moreover, and insurance mechanisms do not add up to ad- community cohesiveness is seriously compromised equate risk management; they also need national and when people are excluded or discriminated against. local governments to complement their efforts. For example, neighborhoods are potentially able to main- Connectedness. Communities also need connections tain their own drains, but urban flood prevention re- to other communities and to markets; without these quires citywide drainage and land use planning that connections they remain small and insular, lack po- only city governments can provide. Similarly, neigh- litical influence, and are unable to accomplish any- borhoods can patrol against petty criminals, but they thing at scale. Communities with strong ties to one are powerless against organized crime. another—that is, those communities that have high “bridging” social capital—are more likely to collab- Promoting inclusion and respect for diversity. Commu- orate with one another on mutually beneficial risk nities are not necessarily fair or reliable and can be management projects and to coexist peacefully. Cities marked by strong inequalities in power and wealth.62 with high religious or ethnically motivated violence, They may exclude vulnerable people (chronically for example, tend to lack routine interaction among ill, widowed), new entrants (migrants, refugees), or members of different groups and to be characterized those who happen to be different (ethnic minori- by divisive local leaders, media, and criminal gangs. ties). The state can help by enacting antidiscrimina- Risk and opportunity 25 tion laws, conducting educational campaigns, and costs.64 Whereas most individuals on their own are encouraging interactions that promote cohesiveness naturally risk averse and thus reluctant to take on in the face of diversity. new ventures, in groups they become more willing Not only can governments support communities, to pursue projects that involve more risk but also but community participation can increase the qual- promise higher returns. Firms, therefore, can serve ity of the governance process and improve the per- as natural vehicles to exploit the upside of risk, with formance of government programs. People may not beneficial consequences for individuals’ resilience heed the call to evacuate when government sounds and prosperity.65 the disaster alarm, but they will run when warned by a trusted fellow community member. Mobiliz- Risk sharing. Enterprises allow risk sharing among ing communities’ voice, energy, and collective action workers through collaboration; among owners of can help overcome some of the obstacles to improv- firms through investment diversification; and be- ing risk management in countries and regions with tween workers and owners through (formal or in- weak government capacity. For example, Afghani- formal) contractual arrangements. For risk sharing stan’s National Solidarity Program is constructing within a given enterprise, achieving a certain size is rural infrastructure with community participation an advantage. The enterprise sectors of many de- and also laying a foundation for improved local veloping countries, however, are dominated by self- governance. In India and Uganda, disseminating ­ employment (figure 5). Rates of self-employment information on health and education entitlements are around 70 percent in South Asia and exceed 80 and outcomes through community-sponsored pub- percent in Sub-Saharan Africa and are also pervasive lic meetings has improved both government services in developing countries in other regions. These high and community participation, leading to more vac- rates of self-employment suggest that the incomes of cinations, more prenatal supplements, and fewer vast numbers of workers in developing countries are excess school fees.63 ­ vulnerable to diverse shocks—a sick child, an equip- ment failure, or a change in the weather could mean the loss of a day’s income and more. They also sug- The enterprise sector gest that the enterprise sector is not benefiting from the specialization and increased productivity that How can the enterprise sector foster resilience multiperson enterprises make possible. and prosperity? The enterprise sector comprises workers and owners, Innovation and resource reallocation. When fueled the arrangements that organize their relationships, by competition, the enterprise sector can promote and the technologies that turn production factors innovation by adopting new technologies and real- into goods and services. Enterprises, the defining locating resources. In some instances, it may require unit of the enterprise sector, range from informal exit and entry of enterprises in the economy. This to formal, from self-employment to partnerships process of “creative destruction,” as first labeled by to giant multinational corporations, and from agri- Joseph Schumpeter,66 can generate substantial ad- culture to manufacturing and services. Whereas the justment costs but may be the only way an economy owner of a single enterprise might seek to maximize remains resilient and prosperous in the face of con- its profits, the enterprise sector as a whole encom- stantly changing conditions. Improving this dynamic passes the interests of workers, owners, and consum- process can have significant effects both on reducing ers. Despite the possible important trade-offs among the risk of prolonged recessions and on increasing these interests, the enterprise sector can help people aggregate productivity. For instance, one estimate manage risk through several channels, as described finds that making resource allocation as efficient in below. China and India as it is in the United States would For workers and owners, being part of a multi- increase total factor productivity by as much as 50 person enterprise—that is, a firm—offers the possi- percent in China and 60 percent in India.67 These bility of sharing the benefits and losses from special- large gains, however, would also require developing ization, collaboration, and innovation. Indeed, this institutions and a business environment that can is one of the main motives behind the formation of support a high degree of dynamism in the enterprise firms. As Frank Knight and Ronald Coase argued sector—not an easy task. in their seminal studies, firms have an institutional advantage in providing cost-efficient ways of deal- Worker, consumer, and environmental protection. Mo- ing with uncertainty and overcoming transaction tivated by reputational considerations and properly 26 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 Self-employment is more prevalent in developing countries, especially in FIGURE 5  Sub-Saharan Africa and South Asia Self-employment, as percent of total employment, average 2004–06 100 Maximum 90 75th percentile Median 80 70 25th percentile 60 Percent 50 40 30 20 Minimum 10 0 OECD East Asia Europe and Latin America Middle East South Sub-Saharan and Paci c Central Asia and the and North Asia Africa Caribbean Africa Source: WDR 2014 team based on data from World Bank World Development Indicators (database). Note: Organisation for Economic Co-operation and Development (OECD) countries in the figure are high-income countries that have been members of the OECD for at least 40 years. All other countries are grouped into geographic regions. regulated by the state, the enterprise sector can con- enterprise sector that is flexible is more capable of tribute to people’s risk management by providing responding to shocks by allocating resources within workplace safety, consumer protection, and environ- and across enterprises, promoting risk sharing, and mental safeguards. These protections are not guaran- innovating in an ever-changing world. In the recent teed, however; and in some cases enterprises do un- global financial crisis, for instance, Denmark and dermine them and generate losses for society. These Spain were hit hard, yet their labor outcomes were harmful practices can be corrected with stewardship markedly different. In Denmark, job separations from the state, communities, and enterprises alike. were high but unemployment spells were short. In Given the right incentives, firms that make these so- contrast, in Spain the unemployment rate, which cial protections a priority can have substantial ben- stood at 25 percent at the beginning of 2013, has efits. A recent meta-analysis, for instance, found that shown few signs of abating since the start of the crisis. workplace wellness programs reduce medical and The difference is arguably explained by the rigidity absenteeism costs—gains that accrue to both work- within the enterprise sector in Spain, in contrast with ers and firms.68 Denmark’s propitious business environment. This situation has prompted a serious debate and recent What characteristics improve the enterprise reform proposals in Spain to remedy the situation. sector’s contribution to risk management? More generally, the evidence indicates that countries with less flexibility in their enterprise sectors suffer Two characteristics enhance the ability of the enter- deeper and more prolonged recessions when nega- prise sector to contribute to people’s resilience and tive shocks occur.69 prosperity: flexibility and, over time, formality. Formality. For enterprises, formality is defined as Flexibility. Flexibility is the capacity of the entire compliance with laws and regulations. Whether enterprise sector (owners, workers, technologies) formality is beneficial (for enterprises and the econ- to adjust to changing conditions. It should not be omy) or not depends on the quality of the norms confused with the simple ease of firing workers. An dictated by the state and the quality of the public Risk and opportunity 27 services it offers. When these norms and services are moving a country from the quintile with the greatest sound, the enterprise sector is characterized by less labor rigidity to the one with the least rigidity im- self-employment and larger, more stable, and more proves the speed of adjustment to shocks by one-half formal firms. These characteristics are all related. In- and increases productivity growth by as much as 1.7 formal mechanisms may be effective for small firms percentage points.73 Furthermore, strong and inclu- and simple transactions, but they are insufficient sive social insurance is necessary so that flexibility in for larger firms and complex relations with workers the enterprise sector does not come at the expense of and markets. With adequate public regulations and the well-being of workers, their households, or their services, formal firms can benefit from better legal communities (box 6). protection (such as contract enforcement) and better use of public infrastructure (such as ports for inter- Stronger and enforceable regulations for worker, con- national trade). That, in turn, can promote risk shar- sumer, and environmental safety. While in many ing and innovation among enterprises. Moreover, areas regulations can be excessive and disruptive of it can make enterprises more easily accountable for market forces, stronger and enforceable regulations their impact on worker safety and on consumer and are needed to ensure workplace safety, consumer environmental well-being.70 protection, and environmental preservation. Market There are both synergies and trade-offs between failures derived from externalities and asymmetric flexibility and formality. In countries with effective information are pervasive in these areas, requiring state institutions, formality enhances flexibility. In direct intervention by the state. The deadly gar- countries with weak state institutions and cumber- ment factory collapse in Bangladesh in 2013—which some regulatory regimes, however, the cost of for- claimed the lives of more than 1,100 workers—is a mality can be too large for the majority of enterprises sad reminder of the importance of the state’s moni- and workers. In this case, informality is a means for toring and enforcement of regulations that cannot be the economy to achieve a certain degree of flexibility overseen by people on their own. These regulations and for workers to access a practical safety net.71 Fig- are important, particularly in states whose low in- ure 6 provides a typology of countries based on the stitutional capacity requires them to prioritize their flexibility and formality of their product and labor interventions carefully. markets. The financial system How can the state contribute? How can the financial system foster resilience Public policy for the enterprise sector requires re- and prosperity? forms that balance the economy’s need for flex- ibility with society’s need for legal and regulatory Through the provision of useful financial tools and ­protections. responsible management of its own risks, the fi- nancial system can shield people from the impact A better business environment. Several of the ways in of negative shocks and better position them to which the state can contribute to productivity and pursue opportunities. Saving instruments (such as innovation can also enhance the resilience derived bank deposits and liquid securities) enable people from the enterprise sector. A better investment cli- to accumulate buffers for rainy days. Credit instru- mate can improve risk management in the enter- ments (such as education or mortgage loans) allevi- prise sector by encouraging adherence to sensible ate financing constraints, helping people to smooth rules and regulations and by increasing the sector’s consumption following negative shocks but also to capacity to adjust to new conditions. Most basi- exploit opportunities with greater flexibility. Finally, cally, secure property rights and regulatory certainty, market insurance (such as health and residential in- along with low costs for firm entry and exit, are es- surance) provides a means to cover the costs of dam- sential. In addition, although labor market reforms aging adverse events. in isolation are unlikely to be successful, reducing the burden of labor taxes and streamlining regulations What characteristics improve the financial is a critical component of a comprehensive set of system’s contribution to risk management? reforms—where the overall effect is larger than the sum of their parts.72 Alongside such complementary Inclusion and depth. As Merton Miller and numer- reforms, recent cross-country evidence finds that ous followers have argued persuasively, when finan- 28 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 F igure 6   Countries vary widely in the flexibility and formality of their product and labor markets More Australia Germany Netherlands flexible Austria Hong Kong Norway Belgium SAR, China Poland Canada Ireland Singapore Armenia Albania Chile Israel Sweden Azerbaijan China Costa Rica Japan Switzerland Cambodia Czech Republic Korea, Rep. United Kingdom Kazakhstan Denmark Latvia United States Peru Estonia Lithuania Finland Malaysia Product and labor market flexibility France Mauritius Benin The Gambia Morocco Botswana Georgia Sri Lanka Brazil Kyrgyz Namibia Republic Hungary Portugal Slovenia Burkina Faso Guatemala Tanzania Bulgaria South Africa Macedonia, Italy Slovak Spain Cameroon Guinea Thailand Indonesia Ukraine Republic FYR Jordan Turkey Côte d'Ivoire Lebanon Uganda Kenya Uruguay Mongolia El Salvador Madagascar Zambia Vietnam Bangladesh Ghana Pakistan Bolivia Haiti Philippines Algeria India Russian Argentina Dominican Lesotho Federation Croatia Bosnia and Honduras Senegal Herzegovina Republic Libya Trinidad and Greece Jamaica Sierra Leone Tobago Burundi Ecuador Mexico Iran, Islamic Rep. Mali Venezuela, RB Yemen, Rep. Chad Egypt, Arab Rep. Romania Nepal Zimbabwe Colombia Nicaragua Less flexible Less formal More formal Production and labor formality Source: WDR 2014 team based on data from World Bank Pensions (database); World Bank World Development Indicators (database); World Economic Forum 2012; and Schneider, Buehn, and Montenegro 2010. Note: Economies in the top row are high (above the median value) in both product market flexibility and labor market flexibility; in the middle row they are high in one or the other of the two; and in the bottom row they are low (below the median value) in both flexibility indicators. Similarly, economies in the first column on the left are low in both formal production and formal labor; in the middle column they are high in one of the two formality indicators; and in the last column on the right they are high in both formality indicators. Only economies with data for all four indicators are considered, and median values are calculated within this sample. cial markets are competitive and function without using financial savings tools in high-income coun- distortions, they can efficiently provide more and tries), and credit is used by about 8 percent (com- better tools and services to more people.74 Indeed, pared with 14 percent in high-income countries)— financial markets can provide instruments and although great heterogeneity exists across countries services that help people face risks of varying fre- (figure 7). quency, intensity, and nature, either idiosyncratic or systemic. However, about 70 percent of people in Stability. The Achilles’ heel of the financial system low- and middle-income countries do not use es- is its propensity for crisis. As observed in the semi- sential financial tools at all, compared with about nal work of Douglas Diamond and Phillip Dybvig, 40 percent in high-income countries. Data on in- the mismatch between the duration of banks’ assets dividuals’ financial portfolios show that financial (long-term) and liabilities (short-term) makes the savings and insurance are each used by only about financial system inherently unstable.75 If the finan- 17 percent of people in low- and middle-income cial system fails to manage the risk it retains, it can countries (compared with 45 percent of people hurt people—directly by hindering their access to Risk and opportunity 29 B ox 6   Should access to social insurance be tied to work status? The provision of basic insurance against the risks associated with ill-  llowing people to participate in health and old-age insurance • A ness and old age—especially for the vulnerable—is arguably a fun- regardless of work status (employed or unemployed, and formal damental goal for public policy. But how is social insurance funded or informal), requiring reasonably short vesting periods and por- and whom does it benefit? Traditionally, it has been funded through table benefits. mandatory payroll taxes levied on employers and employees, and it Making additional contributions to health and pension schemes •  has benefited contributing workers. The problem with this approach voluntary and clearly linked to predictable benefits that are is its limited coverage: in most developing countries, formal workers beyond the basic provisions granted by the state. Involving the (who contribute and benefit from social insurance) make up less than private sector in the management and provision of the voluntary half the labor force (and much less in Sub-Saharan Africa and South portion of social insurance contributions and benefits. Asia). The traditional approach thus ends up excluding many work- ers—mostly those who are low-income, self-employed, or work in Providing basic health care and old-age pensions funded by the •  agriculture.a state and directed to vulnerable populations but potentially open To close the coverage gap, several countries have set up noncon- to everyone (at least for health care).c tributory systems for health and old-age pension insurance. Is it a Funding this basic provision through general government reve- •  good idea to combine noncontributory and mandated contributory nues and user fees (for health care), to a level consistent with fiscal systems? If the benefits from contributing to social insurance are sustainability. uncertain and the enforcement of mandated payments is weak, hav- Clearly communicating with the public the characteristics and •  ing these parallel systems may undermine the incentives for employ- limitations of basic provisions and the additional costs and bene- ers to hire formally and for employees to seek formal employment. A fits of voluntary contributions. vicious circle could then ensue: informality breeds low coverage, and Promoting financial literacy and fostering trust in the financial sys- •  the response to low coverage breeds further informality.b tem regarding its insurance function by macroprudential actions One possibility that merits discussion is delinking social insur- and policy certainty. ance from work status. This uncoupling would involve the following public action: Too ambitious or far-reaching? Maybe so—but worth discussing. Source: WDR 2014 team. a. Ribe, Robalino, and Walker 2012. b. Evidence from Chile, Colombia, and Mexico shows that the interplay of contributory and noncontributory systems has led to declines in formal employment, and there is widespread evidence that smaller, informal firms tend to be less productive and pay lower wages. See Levy and Schady 2013; Pagés-Serra 2010; ILO 2009; La Porta and Shleifer 2008. c. Developing countries such as Mauritius and South Africa already rely primarily on noncontributory systems for pensions, while several other countries— including China, India, Thailand, Turkey, and Vietnam—have also begun to offer universal access to health insurance. See Holzmann, Robalino, and Takayama 2009. finance, or indirectly by hampering available credit nual credit growth of 25 percent, 40 percent, and 70 for enterprises and straining public finances, thereby percent, respectively. Providing the right amount of contributing to loss of jobs, income, and wealth. The credit—not too much and not too little—is a major experience from 147 banking crises that struck 116 concern for all countries. countries from 1970 to 2011 (map 1) is telling: the av- erage cumulative loss of output during the first three How can the state contribute? years of crises was 33 percent of GDP in advanced economies and 26 percent in emerging markets.76 Providing sound financial infrastructure. Financial in- Both synergies and trade-offs may exist between frastructure consists of institutions that facilitate fi- financial inclusion, depth, and stability. By making nancial intermediation, including payment systems, greater and more diversified domestic savings avail- credit information bureaus, and collateral registries. able to banks (and thereby reducing reliance on re- Financial infrastructure also includes a regulatory versible foreign capital), greater financial inclusion framework that fosters both consumer protection and depth can enhance the stability of the financial and competition among financial institutions. Mex- system.77 But excessive financial inclusion and rapid ico and South Africa, for instance, have enacted ef- deepening can endanger stability. This applies es- ficient consumer protection frameworks, which in- pecially to credit markets. For instance, the bank- clude ombudsmen to resolve disputes in consumer ing crises in Thailand (1997), Colombia (1982), finance.78 Competition can lead to innovation in and Ukraine (2008) were preceded by excessive an- financial inclusion, as in the Philippines, which has 30 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 FIGURE 7  Financial inclusion in savings, credit, and insurance across developing countries at different income levels 0.7 THA 0.6 Index of financial inclusion in 2011, MNG 0.5 CHN MYS between 0 and 1 LKA MUS 0.4 BGD ZAF LAO ALB LTU BOL SWZ KEN VNM DOM MNE LBN 0.3 URY HTI PRY CRI RWA KHM ECU AZE LBR UGA ZWE GHA PHL GTM MKD BLR BWA VEN MOZ IDN ARM PER PAN 0.2 SLE NPL COM NGA IND KSV BIH COL KAZ BRA LVA TZA ZMB MAR SRB ROM RUS CHL MWI IRQ SLV GIN TCD MRT CMR NIC HND MEX KGZ GEO BGR ARG AFG SDN UKR 0.1 BFA MLI BEN LSO MDA TUN GAB TUR BDI TGO TJK SEN COG EGY DZA ZAR NER MDG PAK UZB 0 CAF YEM TKM 5 6 7 8 9 10 GNI per capita in 2011, in natural logarithm Sub-Saharan Africa Middle East and North Africa South Asia Latin America and the Caribbean East Asia and Pacific Europe and Central Asia Source: WDR 2014 team based on data from World Bank Global Findex (database) and World Bank World Development Indicators (database). Note: The index of financial inclusion is calculated based on Global Findex data on the use of savings (percentage of adults who saved money at a financial institution in the past year); credit (percentage of adults who borrowed from a financial institution in the past year); and insurance (percentage of adults who personally paid for health insurance, and percentage of adults working in agriculture who purchased agriculture insurance). GNI = gross national income. allowed mobile network operators to take on many prudential supervision and intervene with timely and banking operations.79 Moreover, to promote finan- robust policy tools, as the Republic of Korea did in cial inclusion, the government can lead by example 2011 in the wake of the international financial crisis through innovative practices. An interesting case is by imposing a levy on bank noncore financial liabili- India’s National Rural Employment Guarantee Act, ties to manage speculative capital flows. which has improved outreach to poor people living in Ideally, macroprudential regulation would pre- rural areas through the introduction of government- vent financial crises. Some crises, however, are un- to-person payments using a bank account.80 avoidable, and a crisis resolution system is necessary. How should losses be handled? In resolving crises, Enacting macroprudential regulation for systemic risks. countries should seek to pass bank losses to exist- To better manage the potential for systemic finan- ing shareholders, managers, and in some cases un- cial crises, countries should establish strong macro­ insured creditors—minimizing costs to taxpayers, prudential regulatory frameworks—frameworks that threats to fiscal stability, and future moral hazard. To consider the interconnectedness of financial institu- facilitate recovery from crises, governments and the tions and markets and that address the financial sys- international community can contribute by reduc- tem as a whole.81 Making macroprudential regulators ing regulatory uncertainty through timely decisions independent, possibly by placing them under the cen- and effective global coordination. tral bank, is the first step in this direction—as in the Czech Republic, which in 2006 gave the central bank Taking the trade-offs and synergies between inclusion, explicit responsibility for fostering financial stabil- depth, and stability explicitly into account. Evidence ity. Governments can then pursue pro­ active macro­ suggests that in 90 percent of cases, national financial Risk and opportunity 31 MA P 1  Banking crises around the world, 1970–2011 No banking crisis One crisis Two crises Three or four crises Missing data Source: WDR 2014 team based on data from Laeven and Valencia 2012. Map number: IBRD 40098. sector strategies do not address specific trade-offs in financial markets. Sound macroeconomic man- between financial development goals and the man- agement can provide an environment where house- agement of systemic risk, although more than two- holds, communities, and enterprises are able to plan thirds of countries commit to achieving both goals for the long term and undertake their own risk man- within their strategy.82 A financial policy committee agement. Furthermore, macroeconomic policy can may provide a means for a country to better take address large systemic risks, which households and trade-offs and synergies in the financial sector into other socioeconomic systems are unequipped to account and improve policy coordination. An in- handle on their own. As Robert Barro, among others, teresting example to consider is Malaysia, where the has noted, macroeconomic crises with large welfare central bank takes the lead in engaging major stake- costs have marked the world economy for decades— holders in financial sector policy, including the min- palpably so since 2007.83 Policy makers have an es- istry of finance and private sector experts. The goal sential role to play in preventing these crises or at of this engagement is to prepare a national financial least in mitigating their effects. sector strategy for Malaysia that takes into account trade-offs between promoting financial inclusion Macroeconomic stability. Business cycles are in- and development and managing systemic risk in the trinsic to modern economies, and some degree of financial sector. volatility in aggregate prices, output, and employ- ment is normal. Evidence indicates that the harm- ful effects of volatility do not derive from moder- The macroeconomy ate fluctuations but from high inflation and abrupt How can the macroeconomy foster resilience moves in economic activity. These effects percolate and prosperity? throughout the economy—reducing employment, interrupting credit, and deferring investment—and The macroeconomy is the platform where all eco- produce losses that lead to a decline in long-term nomic activity takes place: from consumption to economic growth. Indeed, analysis across a set of savings in households, from investment to produc- developed and developing countries over four de- tion in enterprises, and from borrowing to lending cades suggests that an increase in GDP volatility 32 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 from normal to crisis-related levels can decrease prudential instruments—aimed at curbing financial long-run per capita GDP growth by around 2 per- imbalances and volatile capital flows—rather than centage points a year.84 through monetary policy.88 Continuous provision of public goods and services. Part Flexible exchange rate regimes. Although debated for of the reason why crises have an impact on long-run a long time, flexible exchange rates have proven to growth is that they can result in an interruption or be effective shock absorbers. That is true whether deterioration in the provision of essential public the shock originated inside or outside the domestic goods and services. These interruptions occur es- economy. Countries with flexible exchange rates tend pecially when governments are forced to undertake to adjust better—recovering more quickly and more drastic cuts in expenditures during downturns. This strongly—to deterioration in their terms of trade,89 was the case, for instance, in several Latin American natural hazards such as earthquakes and storms,90 countries during the 1980s and 1990s, with more and other shocks that may produce internal or exter- than half the fiscal adjustment consisting of spend- nal imbalances.91 ing cuts in infrastructure investment.85 Similarly, social security spending dropped in nearly half the Countercyclical and sustainable fiscal policy. World- countries in the Middle East and North Africa fol- wide, fiscal policy has not made as much progress lowing crises in the region.86 During the latest global as monetary policy in terms of effective process and financial crisis, education budgets fell sharply in the positive results. This is not surprising: fiscal policy is majority of Eastern European countries: for instance, inherently more complex—having multiple objec- by 25 percent in Serbia and 10 percent in Hungary.87 tives and instruments and being immersed in the political process. With respect to risk management, fiscal policy in developing countries has suffered What policies can best contribute to risk from a procyclical bias that has tended to amplify up- management? swings and worsen recessions.92 In the past two de- Experts have argued that macroeconomic policies cades, however, several developing countries around should be credible, predictable, transparent, and the world have put a premium on fiscal transparency sustainable. This is sensible advice. It can also be and discipline, building buffers during good times presented more concretely in terms of risk manage- with an eye toward future downturns. These insti- ment: macroeconomic policy makers should behave tutional improvements explain the recent ability of prudently during upswings to avoid costly coping a large fraction of developing countries to conduct during downturns. countercyclical fiscal policy, mainly by turning in- vestment and consumption spending in a direction Transparent and credible monetary policy. Endowed opposite to that of the cycle in general economic ac- with independence and a drive for transparency and tivity (map 2 focuses on countercyclical consump- credibility, monetary policy authorities have success- tion spending). Independent fiscal councils can pro- fully brought down inflation worldwide in the last vide an important means to further institutionalize 25 years: while 34 countries had annual inflation such discipline (box 7). greater than 50 percent in 1990–94, only 1 country Why is countercyclical fiscal policy useful? First, (Zimbabwe) registered that rate by the end of the it allows governments to continue to provide goods 2000s. Adopting a monetary policy framework that and services and to maintain their public investment creates incentives for long-term price stability, while programs in a stable fashion, even if public revenues accounting for the business cycle, has been crucial to drop (as is normal in the downside of the business defeating inflation. cycle). Second, it provides resources to increase social The 2008–09 international financial crisis and assistance and insurance to larger numbers of peo- the ensuing recession in developed countries have ple in need who are suffering from adverse cyclical tested the improvements made in monetary policy macroeconomic conditions. These two mechanisms in developing countries. All in all, they have proven make a significant contribution not only during the to be resilient. One important issue to consider in recessionary part of the cycle but also for the long- the wake of the crisis is whether financial stability run welfare of people and the economy.93 A third pos- should be included as a direct objective of monetary sible reason is to stimulate the economy. There is little policy. The jury is still out, but it can be argued that evidence, however, that discretionary fiscal stimulus financial stability is best achieved through macro- based on fueling consumption works. To the con- Risk and opportunity 33 Government consumption became countercyclical in more than one-third of developing M a p 2  countries over the past decade Always countercyclical Becoming countercyclical Becoming procyclical Always procyclical Missing data Source: WDR 2014 team estimations based on Frankel, Végh, and Vuletin 2013 methodology. Map number: IBRD 40099. Note: The map shows the evolution of the cyclical stance of fiscal policy from 1960–99 to 2000–12. The cyclical stance is measured in a regression of the (Hodrick- Prescott) cyclical component of general government consumption expenditure on its own lagged value, and the cyclical component of real GDP. The sign of the coefficient on the cyclical component of real GDP indicates whether government consumption expenditure is procyclical (positive sign) or countercyclical (nega- tive sign). The coefficient on the cyclical component of real GDP was estimated separately for the periods 1960–99 and 2000–12. Then, countries are classified as always countercyclical (in both periods); becoming countercyclical (only countercyclical in 2000–12); becoming procyclical (only procyclical in 2000–12); and always procyclical (in both periods). The likely endogeneity of the cyclical component of real GDP was controlled for by using as instruments the (current and lagged value of the) cyclical component of real GDP of the country’s main trading partners and international oil prices, as well as the lagged value of the country’s own cyclical component of real GDP. trary, estimates of the Keynesian fiscal multiplier— Dealing with contingent liabilities requires a combi- the increase in GDP for every dollar of additional nation of measures: first, governments must provide government spending—range only between 0.4 and the right incentives for self-reliance—for example, 0.6 for most developing countries and between 0.6 by replacing pay-as-you-go systems with fully capi- and 1.2 for most developed countries.94 Once the cost talized old-age pension systems, and by letting risk- of raising the necessary additional revenue (in terms takers in financial markets suffer full losses from of taxes, debt, and red tape) is factored in, the net failed ventures. Second, market solutions should be multiplier is likely to be near zero or negative. encouraged by, for example, allowing the issuance of Finally, from a risk management perspective, catastrophe bonds in international markets to insure fiscal sustainability requires being aware of contin- against natural hazards. And, third, resources should gent liabilities. Some of them are legitimate, such be provisioned for residual liabilities that the state as reconstruction and assistance in the aftermath may have to bear. of natural disasters and the larger outlays required to cover social insurance and medical treatment for an aging population. Other contingent liabilities are The international community more controversial; financial bailouts, for example, When can the international community foster can represent a large burden for the state: around resilience and prosperity? 50 percent of GDP in Indonesia and Thailand after the 1997 East Asia crisis, and over 40 percent of GDP Unmanaged risks do not respect boundaries, and no in Iceland and Ireland during the 2008–09 crisis.95 one country or agent acting alone can deal effectively 34 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 B ox 7   An independent fiscal council can help overcome procyclical fiscal bias What is the problem? Fiscal authorities around the world routinely including competitive appointment and long tenure of council deviate from sustainable plans and suffer from a “procyclical” bias: board members, budget independence, and strong accountability they tend to run budget deficits and accumulate debt in good times, mechanisms (such as being evaluated by peer councils or interna- and then lack adequate resources and flexibility (“policy space”) to tional organizations).b stabilize output in bad times. Has this solution been implemented anywhere? By 2012, 22 national A proposed solution. The creation of an independent fiscal council can governments (and counting) had created fiscal councils, with varying provide the right incentives for the government to build up resources characteristics and degrees of relevance.c The Netherlands’ Centraal to cope with cyclical downturns and long-run contingencies. The fis- Planbureau and the Swedish Fiscal Policy Council are the closest to cal council would administer a set of flexible fiscal rules mandated by full-fledged fiscal councils. In Chile, two independent advisory bod- law: deciding on the allocation of deficits over time, signaling when ies provide key inputs for the projection of the “structural” revenue, countercyclical action is justified, and monitoring public debt sus- which in turn determines government expenditure through a fiscal tainability. Full delegation of policy making to an independent fiscal rule. Acting as advisory bodies, fiscal councils in Morocco, Kenya, and council is unrealistic because of the political and redistributive Uganda provide ex ante and ex post assessment of fiscal policies for nature of fiscal policy. The government, following its political man- parliament. date, would retain control over the distribution of expenditures and If a council is not feasible, is there an alternative? Establishing an the structure of taxation. However, isolating some aspects of fiscal independent fiscal council requires the political appetite for auton- ­ policy implementation from the political process and delegating omous institutions and strong governance underpinnings and them to an independent council can enhance fiscal credibility and thus may not be possible in all countries. Where an independent accountability.a council is not ­feasible, a good foundation for fiscal sustainability How can this solution be implemented? Fiscal councils should be would involve adopting transparent and comprehensive fiscal designed in a way that avoids political capture, the rise of govern- frameworks, including top-down approaches to budgeting. Since ment incentives to ignore council advice, or the possibility of being the 2000s, Armenia, for instance, has formulated a three-year roll- dismantled when conflicts within government occur. An effective ing budgetary framework with expenditure ceilings and integrated fiscal council requires independence from the political process— ­ it into budgetary law.d Source: WDR 2014 team. a. Debrun, Hauner, and Kumar 2009. b. Calmfors and Wren-Lewis 2011. c. IMF 2013. d. World Bank 2013. with a risk that crosses a national border. Once trig- countries face severe capacity constraints and have gered, pandemics and financial or economic crises weak or dysfunctional governments.96 That is espe- can circle rapidly around an increasingly intercon- cially the case in fragile and conflict-affected coun- nected world. Armed conflicts can devastate people tries, where people face the most extreme risks and and spill over into neighboring countries. Natural di- obstacles to risk management, with limited access to sasters can ruin a country or an entire region. Climate functioning markets, communities, and public insti- change is likely to intensify all these risks. Clearly, tutions. People living in fragile and conflict-affected risks that spread across and affect multiple countries countries made up 15 percent of the world popula- or generations call for international attention. tion in 2010, but about one-third of people living in The international community is a fusion of rather extreme poverty.97 Conflicts can transcend national diverse agents, including sovereign governments, in- borders, resulting in increased refugee populations, ternational organizations, the global scientific com- spread of communicable diseases, and growing pres- munity and media, and civil society. It can offer ex- sure on public goods in neighboring countries ab- pertise and knowledge; provide protection through sorbing affected populations. Sharing a border with a global rules and regulations, capacity building, and fragile state can reduce a country’s economic growth international coordination; and pool national re- by 0.4 percent annually.98 By improving economic sources to better prepare for risk and alleviate crisis prospects and the environment for health, security, situations. and education, engagement by the international community can reduce social and economic ten- Risks that exceed national capacity. The international sions that inflame and spread conflict, while nurtur- community’s engagement may be needed when ing opportunities. Risk and opportunity 35 International support is also needed when very nizations.101 Increased air travel and trade in goods large shocks, such as natural disasters and finan- and services, for instance, can provide free passage cial crises, result in losses that dwarf a country’s to pathogens that cause infectious diseases, some resources. That can happen even in large and more of which can travel around the world in less than developed countries, as the Euro Area crisis clearly 36 hours.102 Similarly, financial crises can spread demonstrates—although low-income countries are through an increasingly complex network of links disproportionately affected by economic risks and across financial systems around the world. Rapid disasters. For example, the Aceh province in Indo- economic growth that has relied heavily on carbon- nesia bore the brunt of a powerful earthquake and based energy is also related to slowly evolving risks tsunami in 2004, leaving more than 500,000 people such as climate change and environmental degrada- homeless and an estimated economic loss of 97 per- tion, with potentially irreversible consequences for cent of Aceh’s GDP. The international community set future generations. up a special multidonor fund to support reconstruc- tion and establish early warning systems, efforts that What characteristics improve the almost 10 years after the tragedy have largely proven international community’s capacity to to be a success.99 Success does not always follow, manage risk? however, as illustrated by the disappointing results of the international community’s intervention in Haiti The effectiveness of the international community after a powerful earthquake in 2010.100 depends on how well it can fill in knowledge and ca- pacity gaps, establish rules and standards that guide Risks that cross national borders. Openness and nations in managing their risks, and facilitate and modernization have made economic, social, and coordinate collective action to manage risks that go ecological systems increasingly interconnected (fig- beyond national borders. In turn, collective action ure 8). Along with opportunities for growth and is facilitated when agents within the international poverty alleviation, this interconnectedness has community are united by shared preferences and also created a set of risks that cross national bor- objectives, or when certain actors have the ability to ders and require critical risk management from the mobilize resources and enforce agreements—even in international community, including regional orga- the absence of cohesion or unity across nations. FIGURE 8  Economic, financial, and social interconnectedness are on the rise 200 500 180 450 160 400 140 350 120 300 Index Index 100 250 80 200 60 150 40 100 20 50 0 0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 20 Ratio of foreign claims of international banks on all countries to GDP Tourist arrivals per capita Ratio of total trade to GDP Internet users per capita (right axis) Source: WDR 2014 team based on data from World Bank World Development Indicators (database), Bank for International Settlements Consolidated Banking Statistics (database), and World Tourism Organization Yearbook of Tourism Statistics (database). Note: All series are indexed to 100, with 2000 as the base year. 36 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 Cohesiveness through shared preferences and objec- If incentives are aligned: Pursue proactive and well-­ tives. Mutual recognition of the need to address risks coordinated interventions. When incentives are aligned enables the international community to better pre- and a course of action is clear, scaling up risk manage- pare for risks that exceed national capacity—such as ment requires proactive and well-coordinated inter- the arrangements to provide emergency lending to ventions by the international community. In dealing countries facing acute financing shortfalls, and sup- with risks such as pandemics or financial crises in port for regional insurance pools like the Caribbean an interconnected world, the effectiveness of these Catastrophe Risk Insurance Facility.103 Similarly, actions rests critically on supporting the capacity of multilateral cooperation for risks that cross bound- individual countries to monitor and contain risks aries works best when the interests of various nations in their territory. For example, while 36 ­ donors pro- are well aligned and are not overruled by competing vided support to more than 100 developing countries domestic policy priorities. By helping to align na- to prepare for a possible pandemic of avian flu tional interests, the almost universal agreement for (H5N1) from 2005 to 2010, local monitoring was the need to eliminate smallpox facilitated its eradi- ­ essential to contain the virus. More resources should cation. In contrast, in cases where national interests be devoted to supporting capacity building for early diverge, such as resolving climate change risks and warning, monitoring, and communication systems, alleviating the plight of people living in fragile and and to designing risk-pooling solutions that reward conflict-affected countries, progress can be slow. preparation. Power to mobilize resources and enforce agreements. If incentives are not aligned: Use incremental ap- The international community can have a substantial proaches to global solutions. When incentives are not impact on the management of risks when there is a aligned, major sovereigns are not fully engaged, and clear goal around which to mobilize resources. For the consequences of inaction are potentially cata- example, with support from the international com- strophic—as with climate change and other environ- munity, early warning systems have helped reduce mental risks such as loss of biodiversity—the inter- deaths from many types of disasters.104 Similarly, national community should embrace incremental even if complete international consensus is lacking, approaches that can increase traction toward global the international community can make progress on solutions (box 8). To preserve full participation as the risks that cross boundaries if it can devise mecha- ultimate goal, however, special attention should be nisms for enforcing agreements. That capacity de- given to steps that can help align incentives toward pends crucially on the international community’s a common objective, even if alignment seems very ability to realign incentives around shared goals difficult to achieve. For environmental risks, this ef- and to attract participation of major players. A key fort may consist of dissemination of knowledge and element in the success of both the Nuclear Non- advocacy that can help bring diverging views closer, Proliferation Treaty and the Montreal Protocol on financial and technology incentives to countries for the protection of the ozone layer, for example, were steps such as preventing deforestation and inducing the threat of security and trade sanctions, respec- the use of cleaner technologies, and investments in tively, which helped realign national interests and research and development—for example to construct facilitate participation and action. methods for counteracting greenhouse gas con- centration in the atmosphere.105 In a similar spirit, the New Deal for Engagement in Fragile States (the How can the international community Busan Partnership) recognizes that the risk of non- improve its contribution? engagement can outweigh most risks of engagement The insights from the work by Leonid Hurwicz, in fragile countries; it outlines a framework in which Roger Myerson, and Eric Maskin on mechanism de- the international community can work to help them sign for institutions are all the more important for strengthen core institutions and policies and reduce a collectivity as fluid, diverse, and complex as the the risk of reverting to conflict.106 international community. Considering incentive constraints (and not only budget and informational An institutional reform to mainstream risk constraints) is critical to devising effective mecha- management nisms for the international community to contrib- ute to risk management despite its multiple players, The World Development Report 2014 offers dozens complicated power structures, and diverging goals. of specific policy recommendations to improve risk Risk and opportunity 37 B ox 8   For certain global risks such as climate change, the international community should embrace incremental approaches that can lead to global solutions What is the problem? Management of global risks requires proactive Are there successful examples? Some remarkable examples exist. concerted action by sovereign nations. But limited progress in some The Montreal Protocol to protect the ozone layer was originally areas has cast doubt on the possibility of fostering collective action signed by 24 countries but won universal ratification during the among countries with diverging interests, capacity constraints, and 1990s with the combined efforts of governments, international orga- incentives to free ride. Global negotiations to secure agreements nizations, nongovernmental organizations, and scientists.a Likewise, with full participation have stalled—most spectacularly for climate the Limited Test Ban Treaty, whose signatories expanded from 3 to change, where persistent inaction could have catastrophic and 119 between 1963 and 1992, paved the way for the more compre- ­ irreversible consequences. Some potentially useful international hensive Nuclear Non-Proliferation Treaty. actions—including cooperation to develop and share technologies How can it be implemented? Country governments, international and existing financial instruments—have been postponed in the organizations, and specialized entities can form a “coalition of the expectation that they will be part of a “soon-to-be-signed” global willing” to coordinate, advocate, and take action on climate change.b agreement. The coalition can create incentives for others to join over time by pro- The proposed solution. For certain global risks such as climate moting technological change and funding that lowers participation change, the international community should embrace incremental costs (cheaper ways to reduce emissions, subsidies, or technology approaches that can increase traction toward global solutions. When transfers). It can also partner with scientists, civil society, and the incentives are misaligned, major sovereigns are not fully engaged, media to induce participants to comply and nonparticipants to join and the consequences of inaction are disastrous, progress can still be in. International institutions, including an international risk board, made outside a multilateral treaty. Incremental deals and actions by can provide platforms for policy debate and monitor, report, and an initially small group of participants can serve as building blocks aggregate actions to ensure incremental efforts are on the right to global agreements. By demonstrating benefits from action, the path. Strategically, the coalition could anchor its actions to existing expectation is that the group would include progressively more par- global frameworks to demonstrate that incremental and global ticipant countries over time. deals can be connected. Source: WDR 2014 team. a. UNEP 2007. b. Falkner, Stephan, and Vogler 2010; Goldin 2013; Hale 2011. management at different and complementary levels Establish a national risk board to manage risks of society (box 9 provides a summary of these poli- in a proactive, systematic, and integrated way cies). Its overarching advice, however, is that these recommendations should be implemented in a pro- What is the problem? All too often, risk manage- active, systematic, and integrated way to optimize ment strategies and implementation prove ineffec- their effectiveness. For this purpose, the World Devel- tive (or introduce other risks) because they are not opment Report 2014 advocates establishing a national coordinated among all relevant policy stakeholders. risk board, which can contribute to mainstreaming Managing risk in a proactive and integrated way has risk management into the development agenda. This definite advantages: it can help define priorities, en- could be a new agency or come from reform of exist- sure that all contingencies have been considered, and ing bodies: what is most important is a change in ap- avoid overspending to manage one risk in isolation proach—one that moves toward a coordinated and while neglecting others. Some countries conduct na- systematic assessment of risks at an aggregate level. tional risk assessments that involve multistakeholder Implementing this recommendation may require a teams from various ministries and often include the substantial change in the way national governments private sector and civil society. The Netherlands, develop and implement their general plans, moving the United Kingdom, and the United States have from planning under certainty to considering change completed this exercise, and other countries, such as and uncertainty as fundamental characteristics of ­ Morocco, have begun a process toward it. However, modern economies. A national risk board can help this exercise is usually carried out by a temporary, governments overcome the political economy ob- ad hoc group that exists only while the assessment is stacles they face when managing risks at the country taking place. Other countries have created multimin- or even international levels. istry bodies in charge of information exchange and 38 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 B ox 9   Selected policy recommendations from the WDR 2014 The state has an important role in supporting the contributions of For the financial system: all social and economic systems to people’s risk management. The • Sound financial infrastructure (payment systems, credit informa- following summarizes selected policy recommendations from the tion) to facilitate financial inclusion and depth WDR 2014, organized by system, as they are discussed in the Report: • Enforceable regulations that foster both consumer protection and For the household: competition among financial institutions • Macroprudential regulation, for the financial system as a whole, to • Public health insurance, run in partnership with the private sector, lessen financial crises and avoid bailouts with emphasis on preventive care and treatment of contagious • A national financial strategy that addresses trade-offs between diseases and accidents financial inclusion, depth, and stability • Public education, run in partnership with the private sector, with a focus on flexible skills, adaptable to changing labor markets For the macroeconomy: • Targeted safety nets for the poor, for instance conditional cash • Transparent and credible monetary policy, oriented to price stabil- transfers with payments directly to women ity and conducted by an autonomous central bank • Enforceable laws against domestic abuse and gender discrimina- • For the majority of countries, a flexible exchange rate regime, in a tion, accompanied by educational campaigns context of transparent and credible monetary policy For the community: • Countercyclical and sustainable fiscal policy, aided by an indepen- dent fiscal council • Public infrastructure for the mitigation of disaster risks, built in • Provision for contingent liabilities, such as natural disasters, finan- consultation with surrounding communities cial crises, and pensions of an aging population • Transportation and communication infrastructure, especially to integrate and consolidate isolated communities For the international community: • Police protection against common and organized crime, espe- • Engagement in bilateral, regional, and global agreements to share cially targeted to communities under threat risks across countries, enhance national capacity, and confront • Enforceable laws against racial or ethnic discrimination, accom­ common risks, favoring pro­ active and coordinated interventions panied by educational campaigns • For elusive global risks such as climate change, formation of a For the enterprise sector: “coalition of the willing” with like-minded country governments, creating incentives for other countries to join in. • Secure and respected private property rights • Streamlined and predictable regulations for taxation, labor mar- The WDR 2014 advocates that these recommendations be imple- kets, and entry and exit of firms mented in a proactive, systematic, and integrated way. For this pur- • Enforceable regulations for workplace safety, consumer protec- pose, it proposes establishing a national risk board to help main- tion, and environmental preservation stream risk management into the country’s development programs • Consider the possibility of delinking social insurance (that is, and suggests the possibility of an international risk board to support health and old-age pension) from work status the “coalition of the willing.” Source: WDR 2014 team. coordination for risk management, but these bod- tions about appropriate policies to be implemented. ies usually deal with a single risk—most often with Institutionalizing the national risk board should add natural disasters, as in Peru, or national security, as value by enabling risk management to be integrated in Israel. Few countries actually have an integrated, across all sectors, by challenging inaction stemming permanent risk management agency that deals with from political interests, and by introducing clear ac- multiple risks. countability mechanisms for implementing agreed risk management measures.107 What is the solution? To facilitate proactive and inte- grated risk management at the country level, a na- How can it be implemented? The national risk board tional risk board can be set up as a standing (per- should bring together a wide range of stakeholders. manent) committee. It can analyze risks, including It could be either part of government or an autono- trade-offs across risks and across risk management mous agency. The board composition would include policies; consider and publish assessments of risk both policy makers (to reflect political priorities) management practices in the country; define pri- and independent experts (to incorporate techni- orities in risk management; and make recommenda- cal knowledge and private sector perspectives). It Risk and opportunity 39 would have the power to issue “act-or-explain” rec- ommendations to relevant authorities responsible Balancing the trade-offs in the institutional D i agr a m 4  for implementing policy—that is, relevant authori- ties would have to act upon the board’s recommen- design of a national risk board dations or explain why they had decided to reject Independent them. Although the appropriate institutional design experts of the board will depend on the country’s political Lower Lower relevance legitimacy and institutional context, the board’s composition and powers should strive to achieve an adequate balance of expertise, credibility, relevance, and legit- imacy—that is, to fall within the “balanced” region in diagram 4. Balanced Advisory Implementation The board’s policy makers could be nominated role region role by the executive branch of government, and the in- dependent experts could come from academia, the business community, and civil society organizations. The board’s expertise would cover the areas of mili- Lower Lower credibility expertise tary, security and terrorism risk; economic risk; envi- ronmental, health, and technological risk; and social Policy risk. To avoid becoming a powerless body, the board makers should have sufficient prominence in the public eye. Source: WDR 2014 team. And it should be held accountable by regularly pub- lishing its recommendations accompanied by analy- sis and statements of policy priorities and by being subjected to annual hearings in front of a legislative the Homefront Crisis Executive Group, comprising committee. senior representatives from ministries and govern- While an autonomous national risk board may ment agencies. This multirisk framework is comple- have certain advantages, the board could also func- mented by agencies focused on specific risks, such tion as part of government. Indeed, countries as as the National Security Coordination Secretariat. different as Jamaica, Mali, Mexico, Morocco, and Singapore’s institutional arrangement for integrated Rwanda are considering establishing an integrated risk management involves a great deal of specializa- risk management function within the government tion and a complex coordination process that has structure—in part following a proposal by the World evolved over time. For developing countries, a sim- Economic Forum to establish a country risk officer, pler arrangement that involves less specificity and similar to the position of chief risk officer that has specialization in its institutional design (and requires been created in many multinational companies. 108 less demanding coordination mechanisms) may be a This institutional design could be practical in coun- good starting point. tries with a strong framework for an effective and in- Finally, two important questions should be ad- dependent civil service, with the national risk board dressed. First, what can motivate a government to members appointed as expert technocrats with guar- institute a national risk board? An initial impulse is anteed positions for periods that extend beyond the necessary for leaders to overcome opposing incen- political cycle. tives and establish a long-term institution. This im- Singapore’s Whole-of-Government Integrated pulse can come from within the country, through Risk Management framework is an example of an reform-minded political leaders and technocrats, approach that has overcome “silos” within the gov- and from outside, through incitement and support ernment.109 The institutional umbrella of the frame- from the international community. Once created, work is the Strategy Committee, composed of per- the national risk board can challenge inaction or manent secretaries from various ministries across poor practices by introducing clear accountability government and chaired by the Head of Civil Ser- mechanisms for risk management. A reformist gov- vice. In addition, the Homefront Crisis Management ernment interested in the continuation of its ben- system includes a ministerial committee chaired by eficial legacy may want future governments to be the Minister of Domestic Affairs and supported by accountable for their actions or their lack of action. 40 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 The second question is whether a similar body the enterprise sector to grow, develop, and provide can be created at the global level—an international risk management resources to the entire population. risk board—to help address risks that cross national Third, an internally fragmented government that boundaries. An international risk board could in- lacks organization and coordination may end up volve the scientific and expert community around with ambivalent policies or ineffective implemen- the world to pool all available knowledge to iden- tation. This may occur, for instance, as result of a tify, assess, and manage major global risks. Its major defective decentralization process, where local and drawback would be that, in the absence of a gov- regional governments do not have the necessary re- erning body at the international level, it could lack sources and capacities to fulfill their responsibilities, implementation relevance. That could be remedied, do not share the priorities and preferences of the na- however, if the international risk board were to work tional government, or attempt to free ride on other in conjunction with the “coalition of willing” coun- local and regional governments. tries (see box 8), setting priorities on issues to be Finally, the government may be guided by ideol- tackled urgently and offering credibility and legiti- ogy, wishful thinking, or simple desperation when macy to its efforts. confronting difficult and genuine problems, instead of relying on measures based on good evidence and In conclusion: Five principles of public analysis. A common example is labor market regu- lations that purport to defend workers’ interests but action for better risk management wind up protecting only a few and contributing to Analysis throughout the World Development Report the roots of a large informal sector. Inflationary fi- 2014 suggests that, to improve the quality and de- nancing of budget deficits or variable and inconsis- livery of social protection, public goods, and public tent macroeconomic policies in the face of crisis are policy that are essential to supporting people’s risk other examples: sooner rather than later, both paths management, public action can usefully be guided lead to increased uncertainty, macroeconomic insta- by some key principles. The five principles that fol- bility, and possibly even protracted recessions. low reflect the lessons from best practice around the world and are relevant for different types of risks and countries. Their application should be tailored 2. Provide the right incentives for people and to specific contexts, however. Although at first glance institutions to do their own planning and these principles may appear uncontroversial, in ap- preparation, while taking care not to impose plication they involve tensions and trade-offs that risks or losses on others make their implementation a challenge. The challenge for public policy is to create incentives for people to do their own risk planning and prepa- ration, avoiding circumstances in which benefits 1. Do not generate uncertainty or unnecessary are privately appropriated but losses are imposed on risks others. The state’s policies and actions should strive to re- Consider financial bailouts. They are detrimen- duce risks and lessen uncertainty. At a minimum, the tal not only because they can produce a large fiscal state should not worsen them. How or why would burden but also because they provide incentives a government do that? First, through its policies, for excessive risk taking. Yet bailouts are sometimes it may perpetuate social norms that discriminate necessary to prevent a systemic collapse of financial against certain groups and make them more vulner- intermediation. Bailouts should be avoided—most- able. For example, state policies that promote gen- ly by using well-established, clear, and transparent der inequality or ethnic favoritism harm, rather than macroprudential policies—but if bailouts occur, they help, household and community resilience. should be designed to avoid providing the wrong Second, the government may favor the group that incentives for the future. Good examples of orderly supports it politically, whether a small elite or large financial bailouts are hard to find, but the Turkish constituency, against the legitimate interests of oth- experience in the wake of the 2000–01 banking crisis ers. For instance, states that expropriate financial as- (and especially the unwavering stance of the coun- sets (like savings and pension funds) or private infra- try’s bank regulatory and resolution agencies) offers structure (like residential buildings or factories) from a case to analyze and follow.110 some households may obtain short-run gains but end In a very different realm, social protection can be up hampering the ability of the financial system and criticized for not encouraging personal self-reliance Risk and opportunity 41 and being an unsustainable burden to the state. The 4. Promote flexibility within a clear and evidence, however, demonstrates that these prob- predictable institutional framework ­ lems can be avoided by a design that takes people’s incentives directly into account. Well-designed safety Flexibility in adjusting to new circumstances is es- nets—such as conditional cash transfers or workfare sential to promoting resilience and making the most programs, as implemented in Bangladesh, Brazil, of opportunities. Prime examples include household India, and Mexico, to name a few—have promoted migration in response to shifting economic trends, better household practices in the areas of education, rural communities’ adaptation to climate change, health, and even entrepreneurship, while remaining and enterprise renewal in the face of technological fiscally sustainable.111 and demand shocks. Flexibility should not imply In all cases, to manage risks effectively, two arbitrary discretion or haphazard responses, how- changes in people’s mindset related to individual ever. A challenge for the state is to promote flexibility and social responsibility are critical: moving from while preserving a sensible, transparent, and predict- dependency to self-reliance, and from isolation to able institutional structure. cooperation. Providing the right incentives can con- For enterprises, the Danish model of “flexicurity” tribute in both regards. offers such balance, combining ease of hiring and fir- ing of workers alongside a strong social safety net and reemployment policies. The result is a dynamic econ- 3. Keep a long-run perspective for risk omy with high turnover in employment but short management by building institutional spells of unemployment. For the macroeconomy, mechanisms that transcend political cycles inflation targeting regimes with floating exchange A major challenge for public action is to establish rates offer a good model of flexible yet institutionally institutional mechanisms that induce the state to sound monetary policy. By 2012, 27 countries around keep a long-run perspective that outlasts volatile the world had adopted an inflation targeting regime. shifts in public opinion or political alliances. For in- With the onset of the European Monetary Union in stance, the state’s provision of education and health 1999, many countries that had practiced inflation services is a large investment in risk preparation for targeting in the 1990s abandoned the regime. Given families and communities that must be funded on the prolonged recession and uncertainty in the Euro a continuous and sustainable basis to succeed: that Area, monetary flexibility could have been a useful entails long-run planning. In the case of health ser- tool these countries no longer have. vices, Thailand and Turkey offer successful examples with their recent shift to universal health insurance 5. Protect the vulnerable, while encouraging programs. self-reliance and preserving fiscal Consider also the following two examples from sustainability financial and macroeconomic policy. For the fi- nancial system to support risk management, it is The harsh reality is that throughout the world, many essential to strike the right balance between inclu- people do not have the material resources and in- sion and stability. This balance can be assessed only formation necessary to confront the risks they face. through comprehensive long-run planning, like that The everyday struggle to eke out a living can make being done in Malaysia, where the strategy for the planning ahead hard for the poor. The challenge for financial sector is prepared by the central bank, in the state is to protect the vulnerable while preserving collaboration with the ministry of finance and the fiscal sustainability—and encouraging self-reliance. private sector. Countercyclical monetary and fiscal For households that remain highly vulnerable to policies also require a long-run perspective, which shocks, the state can provide safety nets to replace allows them to manage the business cycle by using the costly coping mechanisms that undermine con- resources built over a prolonged time and in dif- sumption, human capital, and productive assets. ferent scenarios. Best practice suggests targeting a Safety nets are possible even in low-income coun- long-run budget balance, as Chile, Colombia, and tries, provided the support is targeted to vulnerable Norway, among others, are doing. Institutional populations and is designed to incentivize work ef- mechanisms that transcend the political cycle— fort. Ethiopia’s Productive Safety Net System, for ex- such as a national risk board and an independent ample, demonstrates how a well-designed safety net fiscal council—can help maintain a long-run focus can protect millions of households from food inse- on risk management. curity while investing in community assets. 42 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 The international community can also provide and opportunities that lie at the heart and core of support to vulnerable populations with resources modern life. So too can the fate of communities and and expertise. Although much criticized, foreign aid countries improve, if they share the continuous re- has been successful when provided in coordination sponsibility required to manage risk successfully. with accountable local institutions. Such was the case when foreign aid helped rebuild infrastructure and “I grew up in a war environment. And what I learned establish early warning systems in Indonesia after the is that you can plan your fate, at least to some degree, if 2004 tsunami. you assess your risk and do something about it.” At the end of the day, protection of the vulnerable Klaus Jacob, disaster risk management expert — entails taking the measures necessary for sustainable at Columbia University and World War II development—development that eliminates extreme survivor112 poverty and allows people to escape vulnerability through the sustained growth that risk management can offer. “There was a time I used to walk to work every day. The route I had to take was dangerous, and many peo- ple were victims [of] robbery and physical abuse. So, Some closing thoughts yes, I have overcome risk to pursue opportunity.” The fate of individuals and families can change for Kariuki Kevin Maina, student, Kenya — the better if they plan and prepare to face the risks Contribution to the WDR 2014 website Risk and opportunity 43 Notes exacerbated the Great Depression (Eichengreen and Irwin 2010). However, the international community has been less Dercon, Hoddinott, and Woldehanna 2005.    1.  successful in avoiding export restrictions during the food   2. Buvinić and Morrison 2000. price crises in recent years (Martin and Anderson 2012). World Bank 2012d.    3.  37. Knight 1921.   4. WHO 2013. 38. Hallegatte and others 2012. Baulch 2011 offers a useful survey.    5.  39. Čihák and others 2012.   6. Paul 2009. 40. For a review of the literature on risk sharing and family and Didier, Hevia, and Schmukler 2012.    7.  network formation, see Fafchamps 2011. Dercon and Christiaensen 2011.    8.  41. Acemoglu and Robinson 2012 compile many examples of See Karlan and others 2012 for Ghana; and Cole, Giné, and    9.  such failures. Vickery 2013 for India. 42. Reinikka and Svensson 2005; Speer 2012; Devarajan, Khemani, 10. Hoddinott, Rosegrant, and Torero 2012. and Walton 2011. 11. Hallegatte 2012a. 43. Becker 1993. 12. While the costs of preparing for risk must be incurred pre- 44. Oviedo and Moroz 2013 for the WDR 2014. dominantly up front, the benefits tend to accrue over time 45. De Weerdt and Hirvonen 2013 for Tanzania; Yang and Choi and are therefore more uncertain. The probability of a risk 2007 for the Philippines; Paulson 2000 for Thailand. materializing is thus central to any assessment of a potential 46. WDR 2014 team based on OECD Programme for Interna- intervention. In formal benefit-cost analyses, this probability tional Assessment (PISA). is usually taken into account either implicitly (by basing cal- 47. Xu and others 2003. culations of averted costs on average historical data) or ex- 48. Demirgüç-Kunt and Klapper 2012. plicitly (by weighting the potential benefit of a risk manage- 49. Duflo 2003; Thomas 1990. ment intervention in the event of a shock by the probability 50. Duflo 2003; see also Thomas 1990 and Lundberg, Pollak, and of that shock occurring). See Wethli 2013 for the WDR 2014. Wales 1997. 13. See, for example, Bodie, Kane, and Marcus 2011. 51. WDR 2014 team based on World Bank World Development 14. See Kuznets 1955 and Dasgupta and others 2002. The trade- Indicators (database). offs mentioned in the text are perceived to exist by some ex- 52. World Bank 2005. perts and a large share of the public, as reflected in opinion 53. Thoresen and Fielding 2011 show how expanding health polls, but may not be present in reality. Recent analyses find, care coverage can put considerable pressure on the sustain- for instance, that economic growth and environmental pro- ability not only of fiscal resources, but also human resources. tection as well as social inclusion are often complementary. 54. Premand 2013 for the WDR 2014. See World Bank 2012b. 55. Paxson and Schady 2007 and references therein; Macours, 15. Hoddinott, Rosegrant, and Torero 2012. Schady, and Vakis 2008; see also references in Fiszbein and 16. Dethier, Hirn, and Straub 2011; Kehoe and Prescott 2007. Schady 2009. 17. Bruno and Easterly 1998. 56. WDR 2014 team based on Demographic and Health Surveys. 18. Bernoulli 1738; von Neumann and Morgenstern 1944. 57. Coleman 1988; Putnam 1993. 19. Allais 1953; Kahneman and Tversky 1979. 58. De Weerdt 2001. 20. Black 1948; Buchanan and Tullock 1962; Olson 1965. 59. Gertler and Gruber 2002. 21. Hurwicz 1960; Myerson 1979; Maskin 1999. 60. For example, Aldrich 2011 shows that social capital plays 22. The concept of a risk chain is discussed and illustrated in a key role in communities’ ability to recover from natural ­ Alwang, Siegel, and Jørgensen 2001. See also Barrett 2002; disasters. Heltberg, Siegel, and Jørgensen 2009. 61. Alesina, Baqir, and Easterly 1999. 23. Ehrlich and Becker 1972. See also the extension in Muer- 62. Narayan, Pritchett, and Kapoor 2009; Bowles and Gintis mann and Kunreuther 2008 and the applications in Gill 2002. and Ilahi 2000; Holzmann and Jørgensen 2001; and Packard 63. Bjorkman and Svensson 2009; Pandey and others 2007. 2002. 64. Knight 1921; Coase 1937. 24. Khokhar 2013 for the WDR 2014. 65. For seminal papers on the topic, see Baily 1974 and Azariadis 25. World Bank World Development Indicators (database). 1975. 26. World Bank 2012c. 66. Schumpeter 1942. 27. For a rich discussion of the potential complementarity be- 67. Hsieh and Klenow 2009. tween insurance and protection, see Erlich and Becker 1972. 68. Baicker, Cutler, and Song 2010. 28. Economist 2013. 69. Bergoeing, Loayza, and Repetto 2004. 29. Hallegatte 2012b. 70. An interesting example of formalization leading to both en- 30. Carter and others 2007. hanced environmental protection and higher incomes has 31. FEMA 2010. recently occurred in Peru. In recent years, informal mines in 32. Gourinchas and Obstfeld 2012; Schularick and Taylor 2012. Peru have sprung up in response to rising gold prices. Ignor- 33. Hallegatte 2012b. ing existing regulations, these informal mines have caused 34. La Porta and others 1998. significant deforestation. The mercury used in the extrac- 35. See, for example, Tornell and Velasco 1992. tion process has contaminated rivers and the atmosphere 36. This kind of trade retaliation was avoided during the and threatened human health. In the La Libertad region, the 2008–09 global financial crisis, in part because of successful Poderosa Mining Company took an innovative approach to coordination by the international community—in contrast the problem after informal miners invaded one of its mining to the well-known “beggar-thy-neighbor” trade policies that concessions. The company began to formalize the invading 44 WO R L D D E V E LO P M E N T R E P O RT 2 0 1 4 miners, signing agreements that allowed them to continue 92. Kaminsky, Reinhart and Végh 2005. mining under its direction. The agreements, which meet in- 93. Parker 2011. ternational environmental management quality standards, 94. See Kraay 2012 and Ilzetzki and Végh 2008 for surveys of the have increased the small miners’ income and decreased literature on developing countries; and Barro and de Rugy the harm from deforestation and mercury contamination. 2013 and Ramey 2011 for surveys of the literature on devel- UNEP 2012. oped countries. 71. World Bank 2012d; Loayza and Rigolini 2011. 95. Laeven and Valencia 2012. 72. Calderón and Fuentes 2012. 96. DFID 2005; OECD 2011a, 2012; World Bank 2011. 73. Caballero and others 2013. 97. OECD 2012. 74. Miller 1986. 98. DFID 2005. 75. Diamond and Dybvig 1983. 99. See “Resilience Stories” at the Sendai Dialogue website at 76. Laeven and Valencia 2012. https://www.gfdrr.org/node/1308. 77. Han and Melecky 2013 for the WDR 2014; Cull, Demirgüç- 100. Larrimore and Sharkey 2013. Kunt, and Lyman 2012. 101. Not all risks that exceed national borders are truly global. 78. Brix and McKee 2010. Some risks, such as armed conflict between neighboring 79. Gupta 2013. countries or disputes over natural resources, may affect only 80. World Bank 2012a. a few countries. Such risks may be more appropriately or ef- 81. Borio 2003 provides a discussion of the differences between fectively managed by regional institutions. a traditional, microprudential regulatory framework and a 102. Jonas 2013 for the WDR 2014. macroprudential regulatory approach. 103. Mahul and Cummins 2009. 82. Maimbo and Melecky 2013 for the WDR 2014. 104. World Bank and United Nations 2010. 83. Barro 2009. 105. Royal Society 2009. 84. Hnatkovska and Loayza 2005. 106. OECD 2011b. 85. Easterly and Servén 2003. 107. Graham and Wiener 1995; World Economic Forum 2007. 86. Prasad and Gerecke 2010. 108. World Economic Forum 2007. 87. Education International 2009. 109. OECD 2009. 88. Svensson 2012; Bruno and Shin 2013. 110. Damar 2007; Ersel and Ozatay 2008. 89. Edwards and Levy Yeyati 2005. 111. Fiszbein and Schady 2009; Alderman and Yemtsov 2012. 90. Ramcharan 2007. 112. Quoted in Eric Klinenberg, “Adaptation: How Can Cities be 91. Edwards 2004; Lane and Milesi-Ferretti 2012; Ghosh, ‘Climate-proofed’?” The New Yorker, January 7, 2013, 33. 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Contents of the World Development Report 2014 Foreword Acknowledgments Overview Risk and opportunity: Risk management can be a powerful instrument for development Part 1  Fundamentals of risk management 1 Risk management can be a powerful instrument for development Spotlight 1 Preparing for the unexpected: An integrated approach to disaster risk management in the Philippines and Colombia 2 Beyond the ideal: Obstacles to risk management and ways to overcome them Spotlight 2 Protecting the food consumption of the poor: The role of safety nets in Ethiopia and El Salvador Part 2  The role of key social systems 3 Households are the first line of support to confront risk and pursue opportunity Spotlight 3 Moving toward universal health coverage in Turkey and the Kyrgyz Republic 4 Cohesive and connected communities create resilience Spotlight 4 Where criminal justice is not enough: Integrated urban crime and violence prevention in Brazil and South Africa 5 Fostering resilience and prosperity through a vibrant enterprise sector Spotlight 5  Moving toward greater labor market flexibility: India’s uneven path 6 The role of the financial system in managing risk: More financial tools, fewer financial crises Spotlight 6  Building resilience to global economic shocks in the Czech Republic, Peru, and Kenya 7 Managing macroeconomic risk: Building stronger institutions for better policy outcomes Spotlight 7  Diseases without borders: Managing the risk of pandemics 8 The role of the international community: When risks exceed national capacity Focus on policy reform Mainstreaming risk management into the development agenda: Selected institutional reforms Appendixes Abbreviations and data notes Background papers Selected indicators Index Four easy ways to order PHONE: MAIL: ONLINE: FAX: +1-703-661-1580 or P.O. Box 960 www.worldbank.org/publications +1-703-661-1501 1-800-645-7247 Herndon, VA 20172-0960, USA Download at openknowledge.worldbank.org eBook available through Amazon, Apple, and other online retailers World Development Report 2014 PRICE QTY TOTAL Risk and Opportunity—Managing Risk for Development Paperback: (ISBN: 978-0-8213-9903-3) SKU 19903 US$35.00 Hardcover: (ISBN: 978-0-8213-9964-4) SKU 19964 US$60.00 Prices vary by country as World Bank Publications offers geographical Subtotal discounts on its titles. Please visit publications.worldbank.org/discounts Within the US (prepaid orders): $8 per order + $1 per item. Geographic discount* Outside of the US: • Nontrackable airmail delivery (US$7 per order + US$6 per item). Delivery time: 4-6 weeks Shipping and Handling** • Trackable couriered airmail delivery (US$20 per order + US$8 per item). Delivery time: 2 weeks. 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The 37 trees •   Publishing and Knowledge Division has cho- 17 million Btu of total •   sen to print the World Development Report energy 2014 Overview: Risk and Opportunity— 3,134 pounds of net •   Managing Risk for Development on recycled greenhouse gases paper with 50 percent postconsumer fiber in 16,996 gallons of •   accordance with the recommended standards waste water for paper usage set by the Green Press Ini- 1,138 pounds of solid •   tiative, a nonprofit program supporting pub- waste lishers in using fiber that is not sourced from endangered forests. For more information, visit www.greenpressinitiative.org, The past 25 years have witnessed unprecedented changes around the world— many of them for the better. Across the continents, many countries have embarked on a path of international integration, economic reform, technological modernization, and democratic participation. As a result, economies that had been stagnant for decades are growing, people whose families had suffered deprivation for generations are escaping poverty, and hundreds of millions are enjoying the benefits of improved living standards and scientific and cultural sharing across nations. As the world changes, a host of opportunities arises constantly. With them, however, appear old and new risks, from the possibility of job loss and disease to the potential for social unrest and environmental damage. If ignored, these risks can turn into crises that reverse hard-won gains and endanger the social and economic reforms that produced these gains. The World Development Report 2014 (WDR 2014), Risk and Opportunity: Managing Risk for Development, contends that the solution is not to reject change in order to avoid risk but to prepare for the opportunities and risks that change entails. Managing risks responsibly and effectively has the potential to bring about security and a means of progress for people in developing countries and beyond. Although individuals’ own efforts, initiative, and responsibility are essential for managing risk, their success will be limited without a supportive social environment— especially when risks are large or systemic in nature. The WDR 2014 argues that people can successfully confront risks that are beyond their means by sharing their risk management with others. This can be done through naturally occurring social and economic systems that enable people to overcome the obstacles that individuals and groups face, including lack of resources and information, cognitive and behavioral failures, missing markets and public goods, and social externalities and exclusion. These systems—from the household and the community to the state and the inter- national community—have the potential to support people’s risk management in different yet complementary ways. The Report focuses on some of the most pressing questions policy makers are asking. What role should the state take in helping people manage risks? When should this role consist of direct interventions, and when should it consist of providing an enabling environment? How can governments improve their own risk management, and what happens when they fail or lack capacity, as in many fragile and conflict-affected countries? Through what mechanisms can risk management be mainstreamed into the development agenda? And how can collective action failures to manage systemic risks be addressed, especially those with irreversible consequences? The WDR 2014 provides policy makers with insights and recommendations to address these difficult questions. It should serve to guide the dialogue, operations, and contributions from key development actors—from civil society and national governments to the donor community and international development organizations. SKU 32791