By: Julian Müller
Civil society organisations (CSOs) campaigning on issues of financial sector regulation broadly have two campaign agendas, namely ‘sustainable finance’ and ‘patient finance’. Both agendas have remained mostly disconnected while in fact, patient finance is more sustainable finance.The voice of CSOs could be more powerful if they recognised this and joined forces to explore and harness the overlaps between the two campaign agendas.
‘Sustainable finance’, as advocated by Friends of the Earth and the Fair Bank Guide International is about integrating sustainability concerns into the everyday operations and governance structures of banks, investors and asset managers, so as to reduce the flow of money to unsustainable business activities and increase, in relative and absolute terms, the amount of money that goes to ‘green’ and other sustainable business activities. The ‘patient finance’ agenda, as promoted by, for example, the Brussels-based Finance Watch, deals more with the classical topics of financial regulation, like capital requirements for banks, consumer protection for retail investors, securities markets regulation etc.
Short-termism (or impatient finance) is well-documented and has increased since the wave of financial liberalisation of the 1970s and 1980s. In OECD countries, the share turnover ratio which measures how often in a year the entire stock of shares in a given economy is turned over, has increased from 33% in 1980 to 138% in 2015 (according to World Bank data), implying that in 2015, each share was on average sold 1.4 times. A recent study by the 2Degrees Investing Initiative has found that even for supposedly long-term equity investors the average holding period of an asset is now only 1.7 years, not much different from the 1.5 year holding period for institutional investors in general. In the banking sector, short-termism is manifested in a move away from illiquid loans to non-financial businesses and into for instance inter-bank lending, or even a retreat from lending altogether and into proprietary trading and capital market-oriented activities. Mortgage loans are often liquidated through securitisation, which involves bundling a mortgage loan portfolio and creating junior and senior tranches that are sold to financial investors.
Why does ‘impatient’ finance create sustainability problems? The main issue is financial materiality. The business risks associated with unsustainable investing and lending tend to, or are perceived to, become financially significant to investors only in the medium to longer term and thus do not breach the financial materiality threshold. Take, for example, the asset write-downs certain companies need to make because of tougher regulation to curb CO2-emissions. Something similar applies to low likelihood risks, such as those related to reputational damage when a company becomes a campaigning target because of its human rights or other abuses. The financial fallout for the affected company can materialise in the short term, but the chance that this will happen during the short period during which a financial investor holds said company's shares or bonds is so small as to make this risk financially immaterial to the investor. Therefore, such risks are usually ignored by an overwhelmingly short-termist financial industry. Reducing such ‘impatience’ by forcing investors to hold on to assets for longer and banks to refocus on lending to non-financial businesses (and sit on those loans) can therefore make a crucial contribution to the integration of sustainability concerns in the financial industry.
The goal of the ‘patient finance’ agenda is to curb the excesses of financialisaton and reduce the sector’s susceptibility to crises by making it, and the financial institutions of which it is composed, smaller and slower. Banks, for example, should be broken up to avoid too-big-to-fail banks, and it should not be made too easy for them to package and sell loans to investors through securitisation, the kind of financial instrument that played an important role in the 2007/08 financial crisis.
The campaign for sustainability in finance would therefore profit if the traditional tools of prudential and securities markets regulation and supervision can be harnessed to make finance patient. CSOs that already work on the classic questions of financial regulation could consider framing their demands and critique also in the language of sustainability, which carries increasing legitimacy, thanks to recent climate change pledges. Regulatory measures should be flanked by industry-driven changes to governance structures, remuneration systems etc. Bodies like the Financial Stability Board's Task Force on Climate-related Financial Disclosures are addressing the materiality issue with regard to climate change, but further research is needed in this relatively new field to elaborate the link between traditional and sustainability-oriented regulation. Other questions are whether the rise of passive investors is likely to exacerbate or decrease short-termism and ignorance of ESG risks, which regulatory measures can be taken to make ESG risks more financially material, and what the industry itself, including financial economists and analysts, can do.
For more information and research opportunities on this topic, please contact Julian Müller firstname.lastname@example.org.