In December I attended a session at the Dutch National Bank (DNB) focused on creating a financial system that was able to energise investment in the creation of a sustainable economy. The stimulus for the session was the publication of the final report of an international Inquiry undertaken by the United Nations Environment Programme on the Design of a Sustainable Financial System. Two things struck me about the discussion.
The first was that nobody knows what the answer should, or could, be and it is unlikely that someone (or some group of people, however clever) could sit down, design the perfect financial system and then implement it. The way forward was to encourage experimentation - stimulate and liberate individuals and groups to try out different approaches and see what works. This approach is in line with how twenty-first century companies and economies are developing. We live in a complex, organic non-linear system. The 19th and 20th century ideas of deliberate, rational design followed by linear implementation no longer works. In an organic, fast-moving business and financial environment, progress happens by opening up to experimentation from which successes will emerge but where some degree of failure is not only tolerated but celebrated as a learning exercise. In other words an entrepreneurial rather than a bureaucratic approach.
The second lesson of note was that almost all of the creative and innovative policy approaches were happening in developing countries. Developed countries, bruised by the financial crash, had become cautious and enveloped in regulation that had the potential to stifle innovation. In Europe, the issue was even bigger as more and more regulatory responsibility for the banking sector was being sucked away from individual markets and concentrated in Frankfurt thereby creating an even more rigid, inflexible and remote regulatory system. This is not to argue against the need for regulation following the financial crash. It is simply to raise the question as to how one can develop a regulatory regime that focuses on that which is systemically important while still encouraging small scale experimentation that has the potential to test and refine new approaches while not having any significant adverse effects when some of those experiments fail. And it's not all about the regulators. Large corporations also, over time, tend to lose their appetite and ability to experiment and innovate.
The meeting at the DNB was encouraging and depressing in equal measure. It was encouraging in that there was a true positive energy behind the discussion and a seemingly genuine desire to craft a financial system that could sustainably support the development of the real economy for the long term. Depressing was the fact that many seemed all too easily to fall back on the bureaucratic approach to get there. One attendee from the pensions industry commented that there was a willingness to move forward but only after everyone had agreed a common approach and a set of common standards. That, of course, is a recipe for endless committee meetings with paralysis of action.
The reality is that there are already many good models out there that can be examined, copied, tried out, modified, refined and, in some cases, eventually abandoned because they don't work. However, a solution to our real and present issues with creating a sustainable financial system is not going to emerge from endless discussions in search of the Holy Grail.
There are many varied initiatives out there that have started to take a different approach to finance and investment in an attempt to create a more sustainable society underpinned by a sustainable financial system. Being relatively new, they can be criticised for being 'unproven.' But that's the whole purpose of experimentation and it should be encouraged. Just a couple of examples among many. Ownership Capital is an investment management company set up to encourage long horizon investment and engagement with both business and ESG issues and is starting to win over some pension funds, so far mainly British ones, to manage a small slice of their investment portfolios. A number of organisations have sprung up offering individual investors the opportunity to invest in early stage companies that have social or environmental impact. Many of these entities are successful and seem to have no shortage of interested investors. So there is a clear appetite and ability to invest sustainably among individual investors but not among pension funds, asset managers and the large banks.
The financial services industry worldwide seems to have little trouble finding innovative ways to boost short-term profits and to richly reward those of its employees who contribute towards that goal. As we have seen in 2008 and since, when those innovations can go disastrously wrong and it is right that regulators work to prevent such systemic meltdowns. However, things don't go badly wrong because of small scale experimentation. They go wrong when organisations build up initiatives that have such a level of scale and risk that, should they go wrong, they are prone to bring down the whole system. For instance, the global financial system currently still has some $550 trillion in outstanding derivatives contracts. It is likely that the real risk associated with these portfolios (as opposed to the largely fictitious, statistically calculated risk) is not fully understood and certainly nor properly reflected on banks' balance sheets. Should (or maybe just when) even a part of this exposure unravel, we're in for another financial crash. On the other hand, small scale, diversified experiments do not carry these types of risks. It is such experimentation focused on sustainable finance that we now need to encourage. Financial companies - both incumbents and newcomers - should seek ways of engaging in such experiments on a limited scale and regulators need to open up the space to allow them to do so without exposure to systemic risk. Both regulators and corporations therefore need a heavy hand focused on systemic risks and a light touch on small-scale experimentation.
The challenge we all face is how to transform our financial system to enable it to support a long term, sustainable, real economy. How do we do that without letting regulatory caution and the inertia of market incumbents become a block to innovation and experimentation while maintaining the status quo even when it is loaded with systemic risk. Can we find the right balance that accommodates both entrepreneurial experimentation and the prudent management of systemic risk?