Is the social usefulness of financial instruments misunderstood in a similar way to how, in the darkness, the aspiring animal musicians in the folktale Town Musicians of Bremen are mistaken for being a witch?
Financial language is confusing at the best of times, sometimes the same term means different things to various people and on other occasions different terms have the same meaning – depending on an individual’s perspective. We should not banish a whole class of financial instrument, like derivatives, just because some have been abused as contraptions of greed.
Context and motive are important. For example, not everyone wearing stockings is a bank robber – but walk into a bank with a stocking covering your face and you are certainly worthy of suspicion!
I decided to write this blog (it’s turned into an essay) after an energetic email exchange with colleagues who work in finance and the social economy across Asia, Europe and the USA. The distribution list expanded to include officials at the European Commission who, refreshingly, found the exchange interesting and informative. (All names withheld to protect the innocent – except mine, I’m guilty of well-meaning provocation)
The discussion was started by a corporate banker at a multinational retail and investment bank, who was writing in her personal capacity. She rightly said that “a serious obstacle to the development of social finance is the lack of standards and common language around the concept”, and that “in a decade of low rates and low average returns, that defining social finance as a ‘poor cousin’ of ‘mainstream finance’ is an inappropriate over-simplification”.
Quite right, and exactly what Rupert Evenett and I argued in Making Good in Social Impact Investment. For example, financial returns are not the top priority of investors who have a capital preservation strategy, for them it is vital that they don’t loose money – and returns in excess of inflation may even suggest that their portfolio has too much exposure to risk.
A new hybrid equity, debt and derivative instrument – you mean Social Impact Bonds for short?
The corporate banker continued to point out that the Social Impact Bond, a new financial instrument being piloted in the UK and explored globally as a means of funding the social economy, is “not strictly a bond [i.e. debt instrument] at all, but rather a structured product of the type that would not be deemed suitable for mass market distribution in many jurisdictions due to use of complex derivatives, limited liquidity etc.” So why are governments, social enterprises, NGO’s and charities around the world so excited about it? Simple, because it is perceived to offer a win-win (and a bit of a compromise) for all stakeholders.
If we unpack Social Impact Bonds based on the individual perspectives of different stakeholders, we see that it cleverly offers to different people exactly what they want:
- Social purpose organisations get access to a steady stream of funding over the timeframe of a few years by being paid for the services they deliver, based on contracts that have terms to suit their immediate cashflow requirements. They are freed of the ‘hamster wheel’ of continuous grant fundraising cycles.
- Governments are able to pick winners through only paying for success and can demonstrate that they are not wasting taxpayers money, but ‘transferring risk to the private sector’.
- Investors with some risk appetite have the opportunity to make investments that can pay well, currently capped at 13% in the UK (perhaps not the most attractive ROI in the UK, but French investors I have spoken to think it is attractive).
- Most importantly (for social economy types) there is explicitly a social objective at the heart of the transaction that dictates the flow of all financial returns. This makes it a potential flagship for the social economy and means that financiers always have a participatory position that is contingent on the success of the underlying social intervention.
One can see the attraction. But if the appeal of Social Impact Bonds is that they are all things to all people, then equally this aspect makes it difficult to put them in a box of financial classification. Social Impact Bonds are:
- Part debt instrument – because financial returns are capped, returns are not open-ended like true equity investments. This means that more of the money can be used for achieving social objectives instead of prioritising financial gains.
- Part equity instrument – because of the higher risk exposure and ‘participating’ elements of the investment in the underlying activity. This is good because it means risk is shared. It is also not usury. (It is import to note that in the UK charities are prohibited from directly issuing equity because they are not permitted to have private ownership, which is an intrinsic aspect of equity capital.)
- Part derivative instrument – because the financial returns to investors are not derived directly from the enterprising activity that is funded, but from a contract between government and financial intermediaries i.e. returns are based on a contract between two parties that pays out based on the performance of a third-party.
Different things to different people
In the Town Musicians of Bremen folktale, the animals inadvertently frighten away the original occupiers of the house. In the darkness, one of the orginal occupiers is confronted in quick succession by the cat’s glowing eyes, the dog’s bite, the donkey’s kick and the rooster’s screech – he concludes that it can only be a witch that has all those attributes. As a result they flee and the animals stay in the house till the end of their days.
We should not allow ourselves to be bewitched (nor seduced for that matter) by Social Impact Bonds, or any other financial instrument. At the end of the day, it’s not how complicated or simple the instrument is that matters, but how it is used, whether the risks are transparent, whether both investor and investee understand the instrument, and whether it is the best instrument to serve the interests of both the investor and investee (not just one party).
The good, the bad and the ugly confusion
In the email exchange I refered to earlier, it was interesting to see the broad variation in opinion amongst social economy practitioners about the pros and cons of debt, equity and derivatives. All were argued for by some, and all were criticised by others as having elements that where not consistent with the values of the social economy.
Here is a great example: one opinion voiced was that the recent financial crisis (a systemic crisis) had a lot to do with debt, arguably too much debt, and that “we borrow wellness from our future”. This may be very true in part, but it doesn’t distinguish between a participating debt investment and a usury loan. The former is inextricably linked to the underlying performance of the investee organisation, very much the same way venture capital (equity) is, whereas the latter could simply have been used to finance someone, a company or a country living extravagantly beyond their means.
But both are debt, the former (investment) is good for society because it seeks to create new wealth, whereas the latter (usury) is not so good because there is no contract for wealth creation, just a requirement to pay interest to the lender.
There is no good or bad when it comes to specific instruments – just good or bad implementation and motive. Consumption based economics fuelled with easy credit certainly does have a lot to answer for.
So I suggest that if we are debating whether debt, equity or derivatives are good or bad – then we are having the wrong debate and using the wrong language.
In the email exchange, an alternative financier operating in Eastern Europe summed up the position very well, she said “I think social finance is defined by what the purpose or motivation of your investment is, not necessarily what instrument you use. I thought that was fairly clear to most of us, perhaps we need to communicate it better.”
In Making Good in Social Impact Investment we explained that if one analyses most equity or debt transactions, there are very few that could be classified as ‘pure equity’ or ‘pure debt’. In fact, most have overlapping characteristics of both equity or debt, quasi-equity and preference shares are two examples. Some financial instruments, such as Contingent-Convertible Bonds (CoCos), are even able to ‘shape-change’ between being debt and equity instruments depending on contingent conditions.
In our report, Evenett and I resurrected the financial term ‘intermediate capital’ – financial instruments with overlapping characteristics of different types of capital – to describe these instruments. More importantly, we wanted to make the point that a vibrant, thriving and efficacious capital market will be comfortable in reflecting these overlapping and sometimes contradictory characteristics. And if we take a step back, we can see how they could all function together in a way that is mutually reinforcing and that supports the fundamental principles and values of the social economy.
After all, diversity and pluralism contribute positively towards reducing systemic risk in financial systems.
We should accept that the social economy in the various corners of the world reflects the nuances and intricacies of local culture, legislation, economic factors, history and financial sector prowess. We should also accept that there will be different opinions about the detail – and that this is healthy.
We need smart legislation
Why are the complex financial instruments of Social Impact Bonds considered good for society but CDO’s and CDO Squared’s are bad?
It’s not the legal instrument that should be evaluated but to what purpose it is put and how it is implemented. Yes, this unfortunately means harder work for legislators and regulators who need to enact smarter and more dynamic legislation and regulation. The rules should not discriminate at the level of the legal instrument or definition, because clever people will always devise workarounds. We need rules that recognise intent and purpose, that filter out the bad and allow the good – whatever it looks like.
Is this possible? Yes, absolutely. For example, the European Commission, in defining what constitutes a Social Business, could have said that for-profit organisations are nasty and excluded, whereas mutuals, charities and cooperatives are good and therefore all are included. But not all of the latter are good for society and not all of the former are bad. So instead the Commission has come up with a set of criteria that defines guiding principles and characteristics by which one can identify social businesses, such as:
- social purpose is mandated
- is pro-market – must be competitive, entrepreneurial and innovative
- surpluses are reinvested for social purpose (does not preclude reasonable profit)
- is transparent and accountable
- decision-making involves workers, customers and people affected by its business
Think that’s fluffy and easy abuse? No it isn’t. To use an extreme example to test the definition: it certainly would not be possible to set up a charitable foundation – so far nothing wrong – that offers a small but wealthy family a tax dodge, does no good for society at large, with no one able to find out about its source of funds because they are channelled via a nefarious tax haven.
Compare it to the following.
… dumb legislation
In the hiatus following the credit crunch and the ensuing blame game, short selling and complex derivatives were blamed as either causing or exacerbating the effects of the crisis – they certainly couldn’t be useful for society, surely? In a knee-jerk reaction, many European Countries banned ‘short selling’ of certain equities. Notwithstanding these bans, the Financial Times recently reported that Credit Suisse is offering its clients products that replicate the hypothetic gains as if they had been short selling European stock indices, including equities covered by eurozone short selling bans.
So what does that tell us? That the taxpayer money spent on those pieces of legislation was wasted. And some clever financial engineers in Switzerland got rich.
We need to turn this tide and make finance work for society and the social economy. It will be a fine balancing act.
What lessons can we draw for creating an efficacious capital market for social investment in Europe
If different types of capital such as debt, equity and derivatives can have overlapping characteristics then defining what is good or bad simply by its headline categorisation is meaningless and keeps the debate in the dark. We should move beyond the trap of defining certain financial instruments as good or bad, and instead focus on evaluating their implementation.
We should welcome financial innovation and not blame it or stifle it, as effectively argued by Bishop & Green in their book Road from Ruin. To quote them describing the Tulip Bubble of the 1630’s, “to blame financial innovation [for the bubble] would be like blaming the tulip”.
We need to work out how we recognise finance that is good for society compared with that which is not. This is easier than people think. As the corporate banker said in our email exchange, we must start with developing standards and a common language.
And the start has been made. See the guiding principles developed by the Task Force for a European Social Investment Facility. It reveals how plurality and diversity can be accommodated, so too can the nuances of differing best practice in different nations and regions.
P.S. there’s always another perspective
In our trans-continental email debate, a contributor from the USA highlighted that Social Impact Bonds remind him of another mechanism in the USA that allows the social economy to raise private capital from the public.
Regular savers are offered Certificates of Deposit (CD) by a well-known bank, these deposits are pooled together and used to guarantee loans to Fair Trade organisations. It’s slightly more high-risk that a regular CD, but the social impact is substantially greater – and there is demand from both savers and borrowers. There are a number of reasons why such a guarantee is preferable to lending the money directly. For example, guarantees help develop the market more broadly by attracting new capital providers, they allow more efficient use of capital by the guarantors, and they provide borrows with the opportunity to demonstrate their credit worthiness by building a track record.
Needless to say, it highlights that sometimes, for some social enterprises, the best way to support them is by providing guarantees and not money directly.
Coming soon: Part 2, focusing on the folly of economic growth…