The finance sector in transition

Co-authors: Pieter Lugtigheid and John Canzi

Introduction

Access to capital has major impacts on society

In the 1970s, the worldwide reaction against the apartheid regime in South Africa led to one of the most renowned examples of selective disinvestment by companies and financial institutions along ethical lines. This disinvestment would ultimately help to overthrow the South African government. In 1971, in response to a growing call for sanctions against the apartheid regime, the Reverend Leon Sullivan, a board member of General Motors in the United States, drew up a code of conduct for doing business in South Africa. This document, which later became known as the Sullivan Principles, attracted a great deal of attention, and several investigations were commissioned by the government to determine how many US companies were investing in South African companies that were in violation of the Sullivan Principles. The ensuing reports led to mass disinvestment by global financial institutes from many South African companies. In turn, this led to increasing pressure from the business community, including banks and insurance companies, on the South African regime to abandon the apartheid system.⁴⁰¹

More than a century earlier, the first agricultural cooperative banks were founded in the Netherlands to provide farmers with badly needed access to banking services and loans. This led to the creation of the first financial institutions for rural communities, such as the Raiffeisenbank. The principles of the Raiffeisenbank would be implemented globally, making a big impact in the lives of tens of millions of farmers. Later the Raiffeisenbank bank became part of the Rabobank⁴"².

In sharp contrast, in 2007 and 2008, the financial sector was responsible for a horrendous financial and economic meltdown, seeing millions of people lose their jobs and their homes, bankrupting hundreds of thousands of small and medium size companies, creating the largest currency and economic crisis in previous decades and even ruining countries.

The examples of the Sullivan Principles and the Raiffeisenbank illustrate how many financial organizations like banks and insurance companies had once, in their founding visions, took important roles in addressing societal issues, being a strong force for good and a powerful leverage for societal change. At the same time, this very same financial sector has shown itself to be capable of greatly damaging society.

So, how did a sector that once had a focus on societal purpose and long-term stability become so fixated on short-term, one-dimensional gains? To understand this, one must understand the current rules of the game in the financial sector. This includes the role of governments as the financial sector is currently heavily regulated and supervised by governments — but this was not always the case. As we explore the often- destructive tendencies of the modern finance industry, a key question emerges: how can finance once again become a significant force for good and contribute to sustainable business and societies?

Economic importance of the sector

The financial industry represents about one-fifth of the world’s economy and in recent decades has grown much faster than the overall global economy. The Organization for Economic Co-operation and Development (OECD) estimates that financial services typically make up 20% to 30% of the total service market revenue and about 20% of GDP in developed economies. In 2011, The McKinsey Global Institute compiled earnings estimates for the sector, focusing on retail banking, life insurance, and property insurance and casualty insurance. These components make up approximately 60% of total financial services sector sales and generate approximately $6.6 trillion in annual revenue, or the GDP of Germany and France combined! During the preceding decade, these sales grew at around 6% per year⁴"’.

The annual revenue of the financial services sector is just a fraction — less than 5% — of the total amounts managed by financial organizations. According to global lending data published by the Bank for International Settlements (BIS), total lending to non-financial sectors was $177.3 trillion at the end of 2017. This included $62.2 trillion to governments, $45.1 trillion to households and $70 trillion to non-financial corporates. If loans to households and non-financial companies are combined, banks were the largest lender group, with loans totaling $67.4 trillion, or 58% of total lending of $115.1 trillion.

Despite the financial crisis in 2008, lending has continued to grow. At the end of 2017, the largest increase was lending to governments (+74%) and the smallest increase was to households (+22%). By all measures, global financial sector lending is very large and is still growing in absolute and relative terms.

Lending and investing services as a driver for sustainability

Financial services are the economic products provided by the finance industry, which encompass a broad range of businesses that manage money. This section will focus on the parts of the financial services sector that provide capital (debt/credit and equity) to other institutions (credit and investments). The geographic scope for this discussion is worldwide.

Many service providers operate within the lending and investing component of the financial sector. These include credit unions, pension funds, hedge funds, venture capitalists, commercial banks, investment banks, credit card companies, insurers, development banks, consumer- finance companies, stock brokerages, investment funds and many other entities that provide credit and make investments. In general, a distinction is made between four types of financial services:

• Commercial banks: A commercial bank (including savings banks

by various names in different countries) is what is commonly referred to as simply a bank. They are supervised and regulated by a range of governmental agencies and legislation;

• • Investment banks: Firms that offer a wide range of services primarily to other businesses and high net worth individuals. These services include managing investments for these clients, initial public offerings (IPOs), mergers and acquisitions, expansion and refinancing strategies, as well as other capital-related activities such as investing advice or buying/selling securities;
• • Insurers: Firms offering property and casualty insurance, life insurance, health, reissuance and disaster insurance. They focus on underwriting risks resulting from human activities, including a very broad range of traditional and new lines of service offered directly or through agents, insurance brokers, and stockbrokers to businesses and consumers. It is very important to note that Insurance firms invest the premiums they receive in various assets including loans and equity, and in this regard are some of the largest institutional investors in the world;
• • Institutional investors: Firms that pool capital to purchase public and privately traded securities, real property, and other investment assets (equity or debt) or to originate credit extensions. Institutional investors include the previously mentioned institutions (commercial banks, investment banks and insurance companies) as well as pension funds, hedge funds, real estate investment trusts (REITs), venture capitalists, private equity firms, endowments, and mutual funds. Other types of firms that invest excess capital in these assets may also be considered to be institutional investors.

These lending and investing activities can, in principle, be used to change and drive sustainable behavior in other sectors, but can unfortunately also obstruct and hinder such behavior, or in fact even drive and stimulate unsustainable behavior. The financial sector we describe in this chapter is therefore instrumental to create the enabling conditions for all other industries to become more sustainable.

Sustainability issues

The global financial services industry is unique in many ways. As we have seen above, it is one of the largest economic sectors. When we talk about the sustainability issues in the financial sector, we can make a distinction in the influence of the financial sector on other sectors (externally), and the sustainability issues within the financial sector itself (internally). As we will see later, both internal and external dynamics are very much related to each other.

External issues: investments as a driver for change

The choices made by the financial sector determine to a very large extent what happens in other industries, economies and countries both directly and indirectly. Directly, investment companies are involved in numerous projects, companies and national investment programs. They decide what they invest in, under what conditions to invest and where not to invest — and therefore what will grow or not. Indirectly, due to their provision of capital through credit and other financial instruments, financial service providers are highly involved in all industries and sectors of society.

There is good news on this front. Traditionally, the decision to invest or extend credit was primarily based on financial and relationship criteria. The criteria will favor established sectors even if they have strong negative externalities. If profitability increased due to such externalities, then this behavior was rewarded by the financial sector with better and more financing opportunities. In the late 20th century, however, a global movement from within the financial services sector began to incorporate data on social and ecological issues as well. This is called ESG (Environmental, Social and Governance) investing. According to a recent article in Forbes, ESG investing in 2018 was estimated at over $20 trillion in assets under management, or around one-quarter of all professionally managed assets around the world.⁴⁰⁴ This is becoming an important trend. Imagine more trillions becoming a force for good. This is the power of the financial sector.

Internal issues: the inherent volatility and instability of the financial services system

The financial industry unfortunately is prone to crises. Banking crises have occurred with some regularity in the USA and Europe. The latest financial crisis was not unique, but it was very severe. On 14 September, 2007

numerous customers of Northern Rock (a savings institution in the UK) rushed to their bank branch to withdraw their savings after reports that the bank was in trouble and had called for emergency support from the Bank of England. Northern Rock was the first retail bank in Europe to fall victim to the credit crisis that had been brewing in the USA for several months. That started to change on 9 August, 2007 when the major French bank BNP Paribas was forced to freeze the repayment of some of its investment funds because its assets — US mortgages — could no longer be valued. Despite actions by the European Central Bank (ECB) and its US counterpart, the Federal Reserve Board and Banks (FED), liquidity dried up on the Inter-Bank market (where banks lend and borrow and settle amongst each other). Financial institutions were in trouble and, for the first time, savers in Europe were confronted with the credit crisis.

The crisis that lay ahead originated with the subprime credit market in the USA: mortgages were given to people with low creditworthiness, sometimes called “ninjas” — meaning “No Income, No Job, No Assets” (people without income, without a job and without possessions). Many of those home loans were made at a variable interest rate. Due to the rise in interest rates in the USA between 2003 and 2007, many borrowers had repayment problems. However, a substantial part of the subprime mortgages had been repackaged (split, combined and bundled with other mortgages) into so called collateralized debt obligations (CDOs). These CDOs were then resold by the original lenders to other institutional investors. This made it difficult to understand where all the mortgages came from and what the collateral was, and therefore identify the real risk was. There was some talk of “toxic credits/products” — people — knew it was risky, but at the time no real regulatory action was taken. It was simply too profitable, and everyone benefitted from it. Now, that started to change.

The bank run at Northern Rock in September, 2007 did not immediately lead to a panic reaction on the stock markets. Wall Street even set a new record on 9 October, 2007. The big shock came a year later, on September 15, 2008 when the financial authorities in the USA decided not to intervene to prevent Lehman Brothers from going bankrupt. The global financial markets shook violently.

Given the growing distrust between banks, the banks that had invested heavily in repackaged loans and were highly dependent on the interbank market for their funding, had a very hard time getting credit from other institutions. That was when the credit crisis became a banking crisis. In the USA and Europe, many banks started to falter, and governments had to support them with billions of euros or dollars. The financial collapse of the Greek government (but not Greek banks) happened during the financial market crisis, and compelled Eurozone members and the IMF to provide a 110-billion-euro bailout package. We thus went from a credit crisis, to a banking crisis, to the start of a major recession and finally to the euro crisis.

The collapsing banks scared consumers and businesses and caused a severe economic recession from the end of 2008 and into 2009. More stringent lending practices also played a role in this recession, which had a strong impact on public finances in many countries and derailed their budgets. Public finances were also burdened by the many billions that had been allocated in several countries to save or support banks in difficulty. The derailing budgets led to reduced creditworthiness of various countries, starting with Greece but quickly followed by Ireland, Portugal, Spain and Italy.

It became clear that the interconnectedness of financial institutions had resulted in an unstable financial system. If stakeholders lost even more trust in financial institutions, the financial system could collapse, impacting the lives of millions of people and forcing governments to intervene. The financial sector as a whole was not sustainable anymore due to its inherent instability, and governments stepped in and invested heavily in many banks and bought most or all of the stock of others.

The rules of the finance game

New rules: high risk and rapid returns

The financial sector traditionally has had problems with sustainability issues — including corruption and money laundering — since the very beginning of its existence. The sustainability issues at the core of this discussion, however, emerged only in the 1980s, when the rules of the game changed fundamentally. These rules not only explain the instability in the financial system, but also why most investments are still made in traditional and unsustainable sectors. To understand how financial service providers can create possibilities to stimulate sustainability investments, it is crucial to first understand what drives the financial sector.

In the 1980s the big changes in the financial world started in Great Britain when it removed regulations and the London Stock Exchange shifted from being one the most regulated exchanges to one of the least regulated. As a result, London began to rival New York as the largest trading center in the world. The banks also benefited from this deregulation, which was called the “Big Bang”: all financial institutions were allowed to trade freely in currency, securities, shares and bonds. Nobody wanted to miss the boat. Meanwhile, the various influences reinforced each other: the increased prosperity, the huge amounts of capital available, the rise of computer-driven trading and the possibility of moving capital abroad.

Most banks increasingly invested to quickly grow their assets and revenues. Anxious to earn high returns, money had to move, and there weren’t enough investments. Instead, they invested in opaque products that promised to generate high returns quickly. New investment vehicles were developed, bundled, cut, encrypted and re-traded many times. As a result, nobody really understood the assets or risks underlying these investments. A large percentage of these products had the housing market in the USA as collateral. As long as house prices rose, there was no problem. However, as soon as housing prices started to fall, the collateral also dropped in value. At that point the value of the investments fell below the benchmark minimum, which triggered a margin call (a call for further deposits of cash or securities to cover possible losses) for many of these products and investments that were tied to an index related to housing prices. As a result, the whole system began to fail, leading to the credit crisis of 2007 to 2009.

Normally, a bank earns money from lending and investing capital from its savers and from investors in the bank’s own securities. This lending provides reliable income to the bank. But in this new era of endless possibilities, these earnings were too slow and too small for the banks and for their shareholders. To accelerate this process, many banks leveraged as much as possible and borrowed more money so they could trade much more on their own account. Compare it with a household. The prudent way of operating is you invest with what is left from your salary. You can decide to buy stocks or invest in real estate. A leveraged way of investment means that this household now lends or invests as much money as it possibly can against everything it owes: the value of the house, the furniture, the car and now all of that money will be invested in stocks and real estate. Of course, this way of working can give you great returns when real estate and the stock market continue to go up. But what happens if the stock market and the value of your home and car which you used to lend all the money goes down as well? This is pretty much what the banks did, they strongly increased their leverage — often from sources that could withdraw their funds in times of crises. This practice makes an individual bank — and when everyone is doing this, the whole financial system — much more susceptible to shocks.

Let’s take a look at how this failure of the financial system relates to the four loops. See Figure 4.21 for an overview of these system loops for the finance sector.

Loop I: market dynamics

First, the financial sector does not produce tangible products. Loans, deposits and investments are administered in digital form and hence the sector does not have a physical limitation to growth. Furthermore, it can operate from anywhere; physical borders are not a constraint. Regulatory constraints can sometimes be avoided by offering the financial service in a regulatory friendly jurisdiction. This allows financial service firms to act very rapidly and escape difficult policy environments which is a challenge for governmental regulation and supervision.

The people, products and service firms in the financial industry are essentially solely focused on making money. Everything is good as long as turnover, profits and financial institutions keep growing. The famous quotation “Greed ... is good. Greed is right. Greed works” (Michael Douglas as Gordon Gekko in Wall Street, 1987) illustrates how the financial sector operated in the 1990s and the early 2000s leading up to the crises of 2008.

Finally, the international financial services sector operates like an oligopoly, with less than 30 players dominating the entire global market.

These factors combined create a market dynamic that is mostly focused on rapidly made, short-term gains.

Loop II: enabling environment

Since the 1980s, the finance sector has been dominated by the economic philosophy of neoliberalism. This involves a policy aimed at enhancing

Figure 4.21 The systemic loops that lead to unsustainable outcomes in the finance sector.

market forces, reducing the size of government and ensuring free trade and unrestricted movement of international capital. Neoliberal policies have spread around the world since the 1980s, after conservative politicians such as Margaret Thatcher and Ronald Reagan started to pursue more market-oriented policies.

In this enabling environment we see “shrinking” governments and deregulation as instruments for more market-oriented public policy, privatization and capitalism. The regulatory frameworks still in place are primarily focused on facilitating growth. For example, many large mergers of financial institutions in the 1990s were facilitated by governments. In this enabling environment financial institutions are in a continuous arms race to achieve the quickest growth themselves, with little room for a broader developmental mindset. As a result of this growth-oriented climate and continuous race towards immediate profits, the oversight on the risks of certain financial products and of the exact allocation of investments, is lost.

Loop III: mismatched benefits and effects

“Remember when nurses, teachers and students crashed the stock market, wiped out banks, took billions in bonuses and paid no tax? No, me neither”.⁴⁰⁵ These words from human rights activist Alakbarov cynically describe the gap between acts and consequences in the finance sector, which might be one of the widest gaps of all industry sectors.

The negative effects of an unstable and unsustainable financial sector are not felt by the banks and investors themselves until it is too late. In fact, the opposite is true. Because of its strong interconnectedness with other industries, the unsustainable and short-term profit thinking of the financial sector actually incentivizes other sectors to behave in the same way, externalizing more and more of their sustainability costs. This in turn results in more profits for the banks again.

Furthermore, as we have seen, the bill for the 2007—2009 financial crisis was not picked up by the financial sector itself; banks that had helped cause the crisis were bailed out by trillions of dollars paid by governments and taxes. Hardly any banker went to jail for the havoc that they helped create. In fact, they did not have to pay back their bonuses. Privatizing profits and socializing losses is what this is called. This is the ultimate externalization of costs and risks to society that can drive any sector to become unsustainable.

Loop IV: lack of alternatives

Were any alternatives available for individual banks in the run-up to the crisis? Given the enabling environment and the market dynamics, few conditions existed for financial institution to substitute the high- risk/high-reward strategies, while the market continued to generate more toxic high-risk products and more profits. The impetuous growth of investments in poorly understood products that were bundled, cut, encrypted and resold became a major problem without adequate external governmental and internal audit (by accounting firm or internal staff) supervision. The risk of these new investment products was essentially unquantified since most of the risks were undocumented and unknown. There was (and still is to a large extend) no transparency about where and how banks are investing their money. To be taken seriously in the market, all financial institutions had to play along. After the crisis it turned out that a large proportion of these products appeared to have the housing market in the USA as a benchmark for their collateral. As soon as USA housing prices fell and the collateral became less valuable, the foundation for all these products and investments collapsed. Confidence in the financial sector then collapsed as well, leading to the credit crisis of 2007-2009.

The sector takes action

These loops clearly show how the liberalization policies in the 1980s, 1990s and early 2000s created a financial system in which the dominant market behavior changed: from cautiously ensuring societal stability to short-term profit-seeking and risk-taking, all in an arena where almost anything was allowed. In that environment, investments were made in whatever yielded the biggest return, accelerating unsustainability in many other sectors, and the climax of unsustainability busting in 2007 and thereafter. Due to this policy and regulatory shift, most large global financial institutions had little room to aim for longer-term stability or to maintain their original societal mission. If they focused on these areas their short-term profits would fall behind their competitors which would in turn drive down the value of their share and debt products.

At present, the finance sector is transforming. Increasingly, financial institutions are starting to address their issues of internal instability and external influence in their investment and lending activities. Due to postcrisis changes, many more legal, regulatory and supervisory demands are now placed on the financial sector. These changes include recovery and resolution plans and programs approved by the regulatory and supervisory agencies (who have often doubled the number of supervisors focused on the biggest banks), a strong stability-focused financial-economic policy formed by international banking standards such as Basel III and IV, periodic stress tests to determine the stability of banks, plus the creation of The Financial Stability Board (FSB) based in Basel — which is led by the major central banks of the world that have set new global liquidity and capital levels that are many times higher than they were in 2008. Overall new behaviors, products and investments are emerging in Europe and North America, albeit very slowly.

Additionally, as an unintended consequence, these changes, alongside an increasing number of sustainability investments, are also impacting the market transformation of other sectors.

In the US, the Dodd-Frank Act was signed in law in 2010 under the Obama administration to help avoid future meltdowns of the financial sector. The Dodd-Frank Act was a comprehensive and complex bill that contains hundreds of pages and includes 16 major areas of reform. Simply put, the law placed strict regulations on banks in an effort to protect consumers and prevent another all-out economic recession.⁴⁰⁶ A concerning fact, unfortunately, is that the Trump administration has revised parts of the Dodd-Frank Act and has given the banks back more freedom to leverage their assets. The Dodd-Frank Act was an unpopular law amongst financial institutions, as it was considered to be too restrictive for banks and investors and would therefore hamper future growth.⁴⁰⁷ It seems like we haven’t learned yet from our mistakes and this might lead to another crisis for the financial sector in near future.

The sector is changing, though. Let’s look at some of the main initiatives that have happened that include sustainability and identify the phases of market transformation these initiatives are in. See Figure 4.22 for an overview of the initatives per phase.

Figure 4.22 Initiatives to drive sustainability investments in the financial market.

Phase r. inception: increasing urgency and move towards actionable alternatives through projects and pioneering

For decades and perhaps longer, sustainable investments were mainly limited to avoiding investing in so-called “sin stocks” like tobacco and war- related companies. Furthermore, investments using religious motives have been around for a long time. This is what we mostly refer to when we talk about Socially Responsible Investment (SRI). These types of investments can be compared to the equivalent of doing pilots and projects in other sectors.

However, due to the debate about sustainable development and fueled by increasing pressure from NGOs about the unsustainable investments made by the financial sector, the financial sector gradually developed its own position, especially in relation to environmental activities by banks.

Phase 2: competitive advantage - creating new business models through innovation and competition

Creating a sustainable finance language

Phase 2 is all about competing on new principles and standards. These principles and standards have changed over time. The collective thinking developed in such a way that, in order to avoid the next financial crisis and enhance stability in the financial markets, it is not enough simply to avoid “toxic products” but to use the power of the financial industry to actually become a force for good by investing in or lending to more sustainable alternatives.

Competition on ESG-related value propositions has resulted in a sec- tor-wide learning process on how to measure responsible investments and how to create a market for them.

In 1992, the United Nations Environmental Program (UNEP) published the Statement by Banks on the Environment and Sustainable Development in 1992, which was signed by over two dozen global banks just before the first global conference on sustainability in Rio in 1992. Through this charter, sustainable development became a more visible part of the financial debate, putting sustainable investment well into the first phase of market transformation. This sparked the development of different frameworks and standards used for sustainable investments that lead financial institutions to explore competing in sustainable finance and investment practices.

In order to understand these standards, we first need to understand the broader concepts on which they are based.

In 1998, John Elkington coined the Triple Bottom Line concept, which refers to the financial, environmental and social factors included in the calculation of the value of a company. This triggered a change in mindset, because the Triple Bottom Line concept identified a new cluster of non-financial considerations that could be included in the valuation of a company or equity.⁴⁰⁸ If financial services providers want to assess the long-term value of a company, non-financial factors like a solid anti-corruption culture, good environmental policies, high net-promotor scores of customers and an above-market performance in terms of research and development provide crucial information about the ability to continue good performance in the future. Therefore, these non-financial factors are also referred to as “future value drivers”.

In 2005, the landmark study called Who Cares Wins⁴¹¹'’ introduced the term “ESG”: it refers to the Environmental, Social and Governance factors that are considered in investment processes. Unlike “socially responsible investment (SRI)”, which accentuates the responsibility of financial actors to decrease investments that are harmful to people and planet, the ESG approach emphasizes the potential these financial actors have to actually increase their efforts to do good in society. Furthermore, the ESGs emphasized that taking these factors into account is not only something “extra: an investor could do, but something that makes good business sense and will lead to better long-term Financial performance.

The language applied

With the rising importance of ESG standards, an array of first-mover investment companies has emerged that specifically deal with ESG-based portfolios. Banks have started to differentiate themselves by offering new value propositions based on impact investing, socially responsible investments and screening on ESG criteria.

Another interesting sector-wide initiative to stimulate sustainable investment competition was the launch of the Dow Jones Sustainability Index (DJSI) in 1999. Since its launch, the DJSI has published an annual ranking of companies based on their ESG score. Besides benchmarking ESG performance in many sectors and highlighting the sector leader (the company with the highest score in the sector), it has also triggered discussions by clients with their financial services providers about the extent to which they are investing in companies with a good ESG score.

In 2014, Oxfam initiated the Fair Finance Guide International (FFGI), together with an international civil society network. It aims to increase transparency for consumers on the social and economic impact of their banks’ investment portfolios.⁴¹⁰ The FFG coalitions have developed a rigorous protocol to assess and monitor bank policies and practices. Every year it publishes a ranking on how banks score on integrating ESG and sustainability criteria in their practices and investments in the hope that it sparks further competition and a race to the top between financial institutions.

Phase 3: pre-competitive collaboration - enabling scaling through collaboration between multi stakeholder coalitions

and platforms

In Phase 3 initiatives, the standards that have been developed are no longer merely used for competition but are increasingly implemented through pre-competitive collaborations. This implementation takes place through disclosures, reporting, recommendations and pressure. Whereas in Phase 2, it was still optional for financial service providers to include ESG assessments, the financial crisis triggered a movement to increasingly make internal and external sustainability the new normal.

The financial crisis of 2007—2009 is considered by many economists to have been the worst since the Great Depression of the 1930s and has severely eroded confidence in the financial sector. Since the outbreak of the crisis, reclaiming trust has therefore become a central theme for many market actors in the financial sector. Banks, insurers, the government as regulator and “lender of last resort”, pension funds and financial intermediaries were all hit by the financial crisis and began looking for ways to restore trust. To do this, financial service providers had to reinvent their contribution to society.

Due to competition on ESG-based value propositions, many financial service providers have gained some experience with this type of innovation. Furthermore, restoring trust is not something that can be done by individual service providers; they need to work together to show clients that the financial sector has learned its lessons and is organizing itself to do things differently.

One of the examples in which there is sector-wide organization is formed by the Equator Principles, that were introduced in 2003. The Equator Principles formed a response to the many social issues the largest banks were encountering when financing projects, especially in countries with less mature legal systems. The Principles are a risk management framework for financial institutions to deal with environmental and social risk in project financing. It was (and still is) primarily intended to provide a minimum standard for due diligence to support responsible risk decision making (UNEP, 2016).⁴¹¹

In 2006, besides supporting the activities of UNEP, the global investment community also joined forces in the initiation of the UN Principles for Responsible Investment (UN PRI). The UN PRI is a network of over 1,750 investors, that collaborate to support each other in incorporating the sustainable principles into their investment practices. In doing this, it recognizes the relevance of ESG factors to both the internal stability of the financial sector, and the sector’s responsibility towards sustainable practices in other sectors.

In 2009, a group of impact-oriented banks joined forces to create the Global Alliance for Banking on Values. This network of 50+ financial institutions, serving 50 million customers and managing US$197.6 billion of assets aims to “use finance to deliver sustainable economic, social and environmental development”.⁴¹² The focus of these banks on ESG performance does not come at the detriment of financial performance; on the contrary, banks taking part in the Global Alliance for Banking on Values had a huge influx of clients (normal consumers) for savings accounts and portfolio management services. Disappointed by traditional banks, their clients found a sustainable alternative in these types of banks.

Traditional banks that have seen their clients leave out of dissatisfaction have started to develop some responsible investment products for clients looking for this, but it has not been impressive. They have continued to concentrate their main focus on the big money-making activities that are still unrelated to sustainability investments.

The increased social pressure on ESG criteria has caused an explosion of research and debate. An increasing number of studies have been published on the relationship between ESG factors and financial performance. One recent study shows, for example, that the inclusion of the most material ESG factors resulted in an average better financial performance of 5%, with extremes ranging from 23% to more than 71%.⁴¹³

In 2010, cooperation between investors was also incentivized by the initiation of the International Integrated Reporting Council (IIRC). The IIRC is a global coalition of business, reporting entities, financial institutes, regulators and the accounting profession focusing on the development and adoption of integrated reporting on an international basis. It aims to create shared principles to report on and measure the sustainability performance of companies and to facilitate sustainability investing. To assess the value creation of a company, the IIRC developed a “six capital framework”: financial, manufactured, intellectual, human, social, relationship and natural capital.⁴¹⁴ This framework is gradually being adopted and applied as a common guideline to communicate the comprehensive thinking underlying the value of a company. This is an important impulse for the pre-competitive cooperation on stimulating sustainability investing.

This multi-stakeholder collaboration builds upon an earlier movement to put pressure on financial service providers in relation to sustainability issues. One example of institutional investors coalescing with environmental groups to use the leveraging power of the financial sector is CERES (Coalition for Environmentally Responsible Economies). CERES represents one of the world’s strongest investment groups, with over 60 institutional investors from the USA and Europe managing over $4 trillion in assets. As a part of this movement, in 2017 the CEO of Blackrock, the largest institutional investor on the planet wrote a letter to all companies it invested in claiming that “Without a sense of purpose, no company, either public or private, can achieve its full potential. It will ultimately lose the license to operate from key stakeholders”.⁴¹⁵ A report in 2017 claimed that of the $87 trillion in assets under management (AuM) by financial services providers, about $23 trillion was in some form of sustainability investmentunitigation of ESG risks ($16 trillion), pursuing ESG opportunities ($6 trillion) or impact investing ($0.25 trillion).⁴¹⁶ That is 26% of all assets under management.

Another good example of financial and non-financial sector cooperation is the Task Force on Climate-related Financial Disclosures (TCFD). Launched in 2015, the TCFD is a market-driven initiative of 31 members, that develops voluntary and consistent climate-related financial risk disclosures. Its aim is to provide better guidance on how to deal with climate-related risk to companies by providing information to investors, lenders, insurers and other stakeholders.⁴¹'' Because climate-related risks are often not easily visible, and are large-scale and long-term, many organizations do not integrate them in their risk perception. TCFD helps them in doing this and creates an awareness of the interconnectedness between Finance and climate.

In 2016, the European Commission established the High-Level Expert Group on sustainable finance (HLEG). In the words of the HLEG’s Chair, “finance needed once more to be placed in service to a global economy facing wrenching challenges of climate change, resource shocks, inequality, demographic shifts and technological disruption”⁴¹⁸. In 2018, this group of NGOs, financial institutions, regulators and governments set a range of recommendations on how public and private capital could be directed towards sustainable investments; these recommendations in turn have become the base for a European Commission Action Plan on sustainable finance, and subsequent actions are still being undertaken.⁴¹⁹

An example of a national initiative leading to cross-sector cooperation for sustainable change in the Netherlands, is the Dutch Financing Task Group. Consisting of representatives of banks, insurers and (pension) funds, the Task Group advises the national sector tables (i.e. platforms where agreements are made to limit CO_z emissions and meet the Paris Accord targets), on the Financial robustness of the various sustainability projects that are conceived at the tables. The Task Group also makes concrete plans and recommendations to facilitate or accelerate the intended transition.

The initiatives mentioned above show how the financial sector increasingly engages other stakeholders, such as governments, companies and investors, to aid them in acting more sustainably. On a deeper level of engagement, the investor initiative Climate Action 100+ was launched in 2017 to assure that 100 of the world’s largest greenhouse gas emitting companies take climate-related actions. Companies that are engaged with the Climate Action 100+ are expected to downsize emissions, improve governance and strengthen climate-related financial disclosures in line with the earlier mentioned TCFD. Failing to do this results in investors potentially taking action.⁴²⁰ In doing this, the Climate Action 100+ integrates the ESG principles by drawing upon CERES and the Principles for Responsible Investment. Climate Action 100+ is thus exemplary of an effort to bring existing standards, principles and reporting criteria together and shows what positive influence the financial sector can have on other sectors by using its power.

In September 2019, a next step was taken in the sustainability of the financial sector. Together with the United Nations, 130 banks, representing one-third of the world’s banking industry and over 47 trillion US dollars in assets, have launched the six Principles of Responsible Banking⁴²¹. Subscribing to these principles, the banks will have to set a minimum of three long-term targets, based on the principles of: (1) alignment of their business strategy with the Sustainable Development Goals, (2) impact and target setting, (3) clients and customers, (4) stakeholder inclusion, (5) governance and culture, and (6) transparency and accountability. The Principles of Responsible Banking are a call to action to move to Phase 4 to create a level playing field in which lending and investing contribute to society.

As we can see, a lot is happening. Increasingly, the financial sector has moved towards great internal stability, and taken up its responsibility to drive sustainable change in other sectors. Starting with statements on its Fiduciary duty, more and more standards have been created on which financial institutions compete, but also collaborate. Nevertheless, more than 75% of total assets are still not yet being invested according to sustainability criteria, so there is a long way to go.

How to move the sector forward

Stakeholders take action

The financial crisis in 2008 has strengthened and accelerated the thinking about the role financial institutions have in society and the use of ESG principles for investing. Since then, we have seen a large uptake and formalization of ESG criteria by leading commercial banks, investment banks, pension funds, and insurance companies. All of the interventions mentioned in the previous section have accumulated, together triggering a major shift in the sector. They have spurred further cooperation and accelerated integration through-out the Financial sector.

Based on where the sector is now, what can stakeholders do to accelerate the move of the financial sector towards internal and external sustainability?

Governments

At the country level, governments now have an important role to play in convening stakeholders in the various sectors and creating impetus towards sectoral and cross-sectoral sustainable change.

National governments and bodies such as the Financial Stability Board (FSB), Bank for International Settlements (BIS), EU and ECB should be clear about the long-term vision of the financial sector. The 2016 report by the EU Fligh-Level Expert Group to advise on future sustainable investments is such an example. Visions like these should be integrated at all policy levels to make clear for the industry what direction is the desired one, that there will be winners and losers in that future and that there is no turning back.

In order to shape and further execute this vision, governments need to stimulate the formation of platform organizations and sector-wide agreements. Collaboration groups such as the Coalition for Environmentally Responsible Economies or the Dutch Financing Task Group are much needed to continue growing a critical mass of finance stakeholders that will drive sustainability in their own sector, and in other sectors.

At the same time, individual banks, investment firms and other financial service providers should be pressured to conduct sustainability reporting, and laggards should be sanctioned. Initiatives such as the Task Force on Climate-related Financial Disclosures should therefore be further stimulated, integrating the entire financial sector.

In summary:

• • Be clear about the long-term vision on the future of the financial sector;
• • Facilitate platform organizations and enforce sector-wide agreements;
• • Enforce the adoption of sustainable finance benchmarks and stimulate financial disclosures;
• • Put pressure on laggards and lobby for financial responsibility at the global, EU and national level.

Financial institutions

As we have seen, since the financial crisis, the sector has already done quite a bit to make itself more stable and resilient and to regain the trust of the other sectors. Nonetheless, there still needs to be a great deal more done to make the financial sector internally sustainable and stable in the long run, as well as to transform it into a driver of sustainable change in other sectors.

Internally, the financial sector should further increase its efforts to be transparent about its own practices, the allocation of investments and the criteria used for these investments. This includes for example, publishing reports that use criteria set up by the International Integrated Reporting Council.

Externally, finance has an important role to play in fostering the transition towards sustainability in other sectors, especially after the COP21 climate agreement. It is estimated that around €180 billion of additional investments per year is needed to achieve the 2030 targets for the EU as agreed in Paris.⁴²² This means that the financial sector needs to accelerate its efforts to redirect investments, and lend out money to projects, organizations and innovation that foster the sustainable transition. Increasingly, this means that the financial sector should move beyond the phase of competition on profits and take joint action.

At the same time, financial service providers that already differentiate themselves on their sustainability efforts, should continue to do so, thus making it attractive to others. The Global Alliance for Banking on Values is one such example. Alternatively, take the Dow Jones Sustainability Index (DJSI), which triggers financial service providers to increase their efforts towards more sustainable performance and enhance their ESG score.

In summary:

• • Increase efficiency and effectiveness of sustainability efforts;
• • Be transparent about allocation of investments and criteria used;
• • Take joint action to redirect investments towards sustainability and finance the COP21 commitments;
• • Enhance competition on sustainability efforts through ESG scores.

Civil society

Civil society organizations play an important role in aiding the frontrunners in their efforts. Also, they should continue to provide platforms to engage in constructive debate with industry and government, while exerting pressure on laggards who are not engaging with ESG and climate-friendly practices. Civil society should therefore further take up its role as a watchdog, leveraging public pressure by concerned individuals, NGOs, media and outsiders. This pressure may consist of reports on potential malpractices by financial service providers or on laggards that do not take part in the wave towards sustainability. Think for example of the Fair Finance Guide International, which benchmarks financial investments in areas such as human rights and climate impact; on a regular basis they expose controversies around these investments, such as when ING financed a controversial coal-fired power station in Indonesia.⁴²³

At the time of writing (July 2019), the European Investment Bank (EIB) has announced it will cut all funding for fossil fuel projects by 2020 to meet the norms of the Paris Agreement.⁴²⁴ This was announced a month after a group of 80 civil society organizations and academics published an open letter to the EIB, in which they demanded the bank quit its fossil fuel financings.⁴²⁵ This example shows that civil society can be a powerful force in making the finance industry more sustainable.

In summary:

• • Leverage public pressure by concerned individuals, NGOs, media and outsiders;
• • Put pressure on laggards through reporting and benchmarking;
• • Lobby for a global level playing field and standards by research and open letters;
• • Establish neutral convening platforms and industry representative groups.

Executive summary

Many financial organizations including banks and insurance companies once, in their founding vision, took important roles in addressing societal issues, being a strong force for good and a powerful leverage for societal change. At the same time, this very same financial sector has shown itself to be capable of greatly damaging society.

The global financial services industry is unique in many ways. It is one of the largest economic sectors by any measure. The financial industry represents about one-fifth of the world’s economy and in recent decades has grown much faster than the overall global economy. The Organization for Economic Co-operation and Development (OECD) estimates that financial services typically make up 20% to 30% of the total service market revenue and about 20% of GDP in developed economies. These components make up approximately 60% of total financial services sector sales and generate approximately $6.6 trillion in annual revenue, or the GDP of Germany and France combined. Despite the financial crisis in 2007—09, lending has continued to grow. At the end of 2017, the largest increase was lending to governments (+74%) and the smallest increase was to households (+22%). By all measures, global financial sector lending is very large and is still growing in absolute and relative terms.

When we talk about sustainability issues in the financial services sector, we should make a distinction in the influence of the financial sector on other sectors (externally), and the sustainability issues within the financial sector itself (internally).

The external issues are looking at investments and credit extensions as a driver for change in other sectors. The choices made in the financial sector determine for a very large extent what happens in other industries, economies and countries both directly and indirectly and therefore what will grow and become successful or not. In the late 20th century a global movement from within the financial services sector began to incorporate data on social and ecological issues as well. This is called ESG investing (ESG stands for Environmental, Social, & Governance). According to a recent article in Forbes, ESG investing in 2018 was estimated at over $20 trillion in assets under management, or around one-quarter of all professionally managed assets around the world.

The internal issues revolve around the current inherent instability of the financial system. Given the fall of Lehman Brothers and the financial crisis that followed, it became painfully clear that the financial services sector was obsessed with short-term growth and financial returns to a point that it resulted in a making the financial system itself unstable.

When we look at the rules of the finance game with hindsight, we can see how that came about and why it was so hard to change it.

Loop I: market dynamics

The people, products and services in the financial services sector are essentially focused on making money. Many financial institutions offer no real (tangible) service or customer care. Everything is good as long as turnover, profits and the financial institutions themselves keep growing every year. In addition, the international financial services sector operates like an oligopoly with a less than 30 players dominating the entire global market. These factors in aggregate result in a market dynamic that is mostly focused on rapidly made, short-term gains.

Loop II: enabling environment

Since the 1980s, the finance sector has been dominated by the economic philosophy of neoliberalism. This involves a policy aimed at enhancing market forces, reducing the size of government, reducing regulation and supervision, and ensuring free trade and unrestricted movement of international capital. The regulatory frameworks still in place are primarily focused on facilitating growth. In this enabling environment financial institutions are in a continuous arms race to achieve the quickest growth themselves, with little room for a broader developmental mindset if they want to maintain their market share and stock price.

Loop III: mismatched benefits and effects

The negative effects of an unstable and unsustainable financial sector are not initially felt by the banks and investors themselves. In fact, the opposite is true. Because of its strong interconnectedness with other industries, the unsustainable and short-term profit thinking of the financial sector actually incentivizes other sectors to behave in the same way, as they externalize more and more of their sustainability costs.

Loop IV: lack of alternatives

Given the enabling environment and the market dynamics at the time, no conditions existed to substitute the high risk/high reward strategies while the market continued to generate more toxic high-risk products and more profits. There was (and still is to a large extend) no transparency about where and how banks are investing their money. To be taken seriously in the market, all financial institutions had to play along.

These four loops clearly show how the liberalization policies of the 1980s, 1990s and early 2000s created a financial system in which the dominant market behavior changed: from cautiously ensuring societal stability to short-term profit-seeking and greater risk-taking. At present, the finance sector is slowly transforming, driven to a large extend by stricter regulations by governments and central banks, as financial institutions increasingly address their issues of internal instability and external influence in their investment and lending activities.

When it comes to responsible investing the ESG principles have seen a steady rise since 1992. Of the total of $87 trillion in assets under management by financial services providers, about $23 trillion was in some shape or form a sustainability investment: Be it mitigation of ESG risks ($16 trillion), pursuing ESG opportunities ($6 trillion) or impact investing ($0.25 trillion). That is 26% of all assets under management. In 2019 a next step was taken in the sustainability of the financial sector, as the UN and 130 banks, representing one-third of the world’s banking industry and over US$ 47 trillion in assets, launched the six Principles of Responsible Banking. Subscribing to these principles, the banks will have to set a minimum of three long-term targets, based on the principles of:

• 1. Alignment of their business strategy with the Sustainable Development Goals;
• 2. Impact and target setting;
• 3. Clients and customers;
• 4. Stakeholder inclusion;
• 5. Governance and culture, and;
• 6. Transparency and accountability.

It has taken decades to get here, but the financial sector seems to be ready for change.

We believe the ESG principles are at the middle or at end of Phase 3 of the market transformation curve. It is now time to call upon all stakeholders to make the ESG principles the new normal. In this phase the governments and the multilaterals are the key players as the front running financial institutions are already calling for a level playing field. National governments and bodies such as the EU, Bank for International Settlements (BIS) and Financial Stability Board (FSB) must be very clear about the long-term vision of the financial sector. These visions should be translated into regulations, supervisory policies and laws, and these should be integrated at all policy levels, as to make clear for the industry what direction is the desired one, that there will be winners and losers in that future and that there is no turning back. The other stakeholder groups should do all in their power to put pressure on the laggards in the system and lobby for strict legislation and compliance that all investments and credit extensions are meeting strict criteria for sustainability.

Going forward, with the ESG principles at the heart of the financial services sector, perhaps the financial sector can regain the claim that they are a force for good and it is here to find solutions for creating a more sustainable future.

5