The economic crash of 2008 shook people’s confidence in the financial system. Images of greedy bankers playing fast and loose with regulations – and clients’ money – came to dominate public consciousness.
Of course, the reality is not quite so clear-cut. Banks and investment managers make mistakes, and some of them act irresponsibly, but financial institutions also deliver valuable services that benefit businesses and individuals across the income spectrum.
However, there is always more that the financial sector can do to improve the services it provides to its customers and clients. Primarily, it must always see access to capital as a means to an end, not the end itself. Financial institutions can pull individuals out of poverty, provide opportunities to businesses and help people build better lives, but only if they promote fair and sustainable banking.
One of the key functions of the financial system is to match the supply of capital with demand to create sustainable value in the economy. Capital flows to and from the three main users of finance – households, businesses and governments – and passes through a range of intermediaries in the investment and lending chain. Returns and accountability for managing these funds then flow back to the beneficiaries.
The fundamental purpose of a sustainable financial system is to serve both the economy and wider society
The responsibilities, incentives and regulations governing financial intermediaries in the investment and lending chain profoundly influence the direction of capital towards productive and sustainable investments. Influencing these governing characteristics is fundamental to ensuring that the financial system is stable and productive.
However, at the heart of the sustainability challenge are two misalignments: one concerns the appropriate time scale; the other concerns the appropriate conception of risk.
Key objectives such as job creation, environmental protection, retirement financing and climate transition require a focus on the long term and a broad perspective on potential risks. Yet much of the financial system is biased towards the short term and has a narrow view of financial risk.
These misalignments pose a challenge for investors and firms entrusted with capital, placing on them a duty to consider long-term sustainability risks.
Taking account of sustainability risks should be integrated into the duties of investors, whether through fiduciary duty in common law or its equivalent in other legal systems. These duties should then cascade down to the other participants within the investment and lending chain.
From such duties, it follows that both the governance of financial institutions and the agencies that supervise them have to be developed simultaneously. In parallel, policy and regulatory interventions will go hand in hand with the advancement of market-based tools essential to investment decision-making, such as benchmarks and credit ratings.
A sustainable future
Sustainability is the model for future economic development, and finance is an essential factor in achieving ambitious goals relating to economic prosperity, social inclusion and environmental regeneration. Underpinning these objectives is better environmental, social and governance (ESG) disclosures by firms, which should accumulate over time to give an accurate picture of their performance.
Developing broadly accepted industry standards relating to measures of carbon emissions, human capital and health and safety would support better-informed decision-making.
The fundamental purpose of a sustainable financial system is to serve both the economy and wider society. The activities and resources of the financial system are there to underpin balanced prosperity and competitiveness, as well as to promote innovation that boosts social inclusion, respects the environment, protects the climate and delivers on objectives for human rights.
For the financial system, sustainability has a dual imperative. The first is to ensure that ESG factors are at the heart of financial decision-making. The second is to invest capital in ways that help solve the challenges facing society that require long-term finance: creating jobs, improving education and retirement finance, tackling inequality and accelerating the shift to a decarbonised, resource-efficient economy.
A sustainable economy must not only protect natural resources but also have high employment levels and financial and economic stability.
Much has been done to strengthen the financial system following the crisis, but it still does not function as effectively as it could. Achieving sustainability requires a long-term approach – both in terms of providing funding for critical infrastructure and responding to threats.
If the financial system can address the long-term – yet pressing – risks and opportunities related to climate change, it will have developed processes, approaches and thinking that can be drawn on to deal with other deep-rooted sustainability challenges.
In order to meet the United Nations’ sustainable development goals, they must first be translated into effective policy proposals that are capable of mobilising the financial system. Long-term policy objectives for sustainable development and climate action need to be refashioned as robust policy signals that provide incentives for the allocation of capital to sustainable investments.
The persistence of external environmental and social costs that are not reflected in market prices and valuations means that sustainability does not always appear to be an obtainable objective. This results in an insufficient supply of sustainable assets with attractive risk/reward characteristics, and in missed opportunities to invest in job creation, innovation and environmental improvement.
A range of practical issues within financial institutions and markets are holding back progress. There remains a lack of industry standard definitions, and the current quality of disclosure is insufficient to enable informed decision-making and oversight. Financial incentives and the business models of intermediaries are not yet fully aligned with sustainable development.
Alongside this, financial institutions need to better understand the sustainability expectations of individual savers and investors. In addition, levels of literacy and expertise around the issue of sustainability are often inadequate along the investment and lending chain.
Looking long term
If things remain as they are, the financial system and related policy frameworks risk succumbing to the ‘tragedy of the horizon’, an issue that arises when financial outlook is short term and so doesn’t factor in long-term issues such as climate change, demographics, technology or the benefits of long-term investment, thus blinding financial institutions and policy-makers to their implications.
Firms and financial institutions that wish to make long-term investments are often subject to short-term market and regulatory pressures, and so under-invest in human, technological and natural capital. The result is maturity mismatches between long-term projects, long-term risk materialisation and their short-term market liabilities.
As the largest asset pool in the EU, banks play a key role in sustainable lending, but the overall level of sustainable investments is unclear. Banks remain the main source of external finance for households and small and medium-sized enterprises, as well as roughly 80 percent of green infrastructure finance.
The rapid evolution of the sustainable finance agenda could provide the best opportunity for the world to reorientate its financial system from short-term stabilisation to long-term impact.
In a narrow sense, sustainable finance means integrating ESG criteria into financial investment decisions. In a broader sense, it refers to a financial system that is promoting sustainable economic development rather than boom and bust, sustainable social development rather than inequality and exclusion, and sustainable environmental development rather than damaging natural resources.
Achieving this requires a clear vision – one that can be understood, implemented and measured in practice.