Since the financial crisis of 2007/8, there remains an enduring understanding amongst commentators that the financial system, as it was structured up to 2007, was a major contributor to the crash. There are also well understood flaws in the system that, if rebuilt in the same way, are likely to be major barriers to supporting a sustainable, and socially just, economy. Issues such as short termism, the conflicts of interest between principal and agent in the investment supply chain, failure of the system to place value on environmental & social risks, and the sheer complexity of the financial markets all play a role in steering capital away from socially useful purposes just at the time we need it most.
The Finance Innovation Lab, a partnership between WWF UK and the Institute for Chartered Accountants of England and Wales (ICAEW) is building a network of finance experts, NGOs, social entrepreneurs and academics dedicated to stimulating systemic change to the finance system that serves the public good. A theme that comes through is that if change is going to happen, it will probably come through in a disruptive way. No government will be able to either design the perfect finance system or force through all the change itself. Left to their own devices, the existing finance market players have no interest in changing the system for the public good if it threatens their position. New financial innovations and business models struggle to challenge the status quo on their own. Put these three forces together, however, and more systemic change is possible.
We have mapped some of the policy ideas being researched and advocated in this area that are designed to disrupt the finance system in order to transform it to one that can support people and planet. The good news is that there are a lot of new ideas out there but so far only a few have become prominent in mainstream debate. Despite this, however, there is a latent political demand for changes to the financial system which is coming from left and right. Frustration from shareholders against top pay, appreciation that the German banking system was far more resilient than that in the UK, and the growth of the peer-to-peer lending sector, all show the potential for disruptive change is growing.
Disruption can come from three directions: it can be imposed by government and regulators in a top down way, it can come from mainstream players changing the way they operate, or it can come from new business models rebuilding the system from the bottom up. The Finance Innovation Lab has been reviewing options and working with those with the most promising ideas.
One of the most exciting areas of socially useful financial innovation, where the UK has really taken a lead, is the peer-to-peer finance sector. Companies such as Zopa and Funding Circle are using internet platforms to facilitate direct lending contracts between individuals and companies. By cutting out the banking middle man, they can simultaneously provide savers with higher returns and borrowers, be they individuals or companies, with lower interest rates. Many, including Andy Haldane from the Bank of England, are predicting that this business model could provide serious competition to high street banks in years to come. But at the moment their growth is undermined by regulation which favours traditional savings accounts in banks in terms of tax treatment, and a regulator (FSA) that doesn’t really have the tools to engage with such innovative new entrants. Simon Deane-Johns, a lawyer who was one of the co-founders of Zopa, has set out a series of recommendations for proportionate regulation of the peer-to-peer sector, but the government is so far leaving these new innovators to find their way in the market. Here we have financial innovators who want some regulation, in a way to demonstrate the safety of their products to customers, and a government failing to act.
A similar development is happening in the field of banking itself. As the large, too-big-to-fail banks are increasingly ignoring small businesses, there is a surge in interest in creating new, local banks to fill the gap in the market. Many are looking to the experience of the German banking system, which has a whole tier of local savings banks, the Sparkassen, held in trusts and controlled by boards of local stakeholders. Whilst the 2007/8 credit crunch saw large international banks in the UK and Germany withdraw finance from SMEs, thus transferring the banking crisis to the real economy, the Sparkassen actually increased their lending. This could well be an important factor behind the strength of SMEs and manufacturing in Germany. The centre-right think tank Civitas has recently published the report Street Cred which details recommendations for how to stimulate such a revival of local banks in the UK. Again, there are concerns that because our financial regulation is designed to accommodate large international banks, it cannot handle small new entrants which only wish to deliver fairly simple financial products. Banking licenses can take years to obtain, creating a financial and knowledge barrier to entry, which benefits the incumbents, and not the consumer.
These two examples are very ‘bottom-up’. To stay with banking, there are two other examples of how government could act to help create a more sustainable finance system. First, it could use tax incentives to reward responsible finance practices. Green Alliance, the environmental think tank, has recently produced a report, Saving for a Sustainable Future, advocating that any tax relief given to savings or investments, such as pension tax relief, or Individual Saving Account tax allowances, should be accompanied with some conditions of responsible finance. For example, what if a bank could only have the right to issue a tax-free savings product if it complied with transparency rules so that we knew what sectors of the economy it was lending to year on year. This idea might encourage some of the mainstream players to lend more responsibly.
A more radical, top down, approach to control the excesses of the banking sector comes from economists who are questioning the value of a great deal of the lending activity of banks. Bank of England figures, analysed by the New Economics Foundation, show that only a small proportion of lending from the banks actually goes to businesses (less than 20%). Far more goes to either finance property, through mortgages, or to other financial institutions, often for speculation. Economists such as Professor Richard Werner and Ann Pettifor are arguing that governments or central banks should be controlling the flow of credit in the economy by limiting the amounts that can go towards different parts of the economy. Many of the East Asian economies, including Japan in the 1950s and 60s, controlled the amount of credit that its banking system could allocate for financial speculation. One of the consequences was the amount of investment that went into infrastructure, domestic manufacturing and other productive parts of the Japanese economy, helping to build its ‘economic miracle’.
A similar analysis of disruptive thinking can be applied to other parts of the finance system, particularly the institutional investment side and how it interacts with the equity markets. Groundbreaking work in organisations like Fair Pensions, Carbon Tracker Initiative, the Network for Sustainable Financial Markets and the Climate Bond Initiative all deserve a mention here, as does the newly created EU public interest organisation, Finance Watch.
The ideas for creating a new and sustainable finance system are out there and being developed. This thinking deserves far greater exposure to policy makers and the media. If it doesn’t then the system will be rebuilt much as it was in 2006, and the world of finance will remain a barrier to social and environmental progress.