It’s the plumbing stupid!
Everyone thinks the financial system is broken and they’re not wrong. But how do you fix something as vast and complex as this? Easy, simplify it. I don’t mean by doing away with massive parts of it (although there are some that would find this attractive). I mean put it in terms that we can all understand, and when it comes to the financial system I like to think of it as nothing more than, well, plumbing.
The role of the financial system is to take surplus capital from those that have it and channel it to those that need it and offer the most attractive perceived risk / return profile. All those organisations, be they banks, private equity, institutional investors, venture capitalists, insurers and reinsurers and even hedge funds are all part of this. It is their role to price and manage risk and allocate capital based on this analysis.
Last week the G20’s Financial Stability Board (FSB) Taskforce on Climate Related Disclosures (snappy title!) delivered its final recommendation after two years of work. Importantly it recognises that the governance and risk management practices of an organisation are an important context for understanding the financial results published in all those glossy annual report and accounts. Without transparent disclosure of this contextual information it is much harder to interpret the financial results. This means we are significantly more likely to suffer a misallocation of capital, a la 2008.
Mark Carney, Governor of the Bank of England and FSB Chair, said: “Financial markets have the potential to improve our prospects for tackling climate change, but only if we make climate risks and opportunities more transparent. … Along with analysis of wider market conditions, investors need accurate data. The more incomplete or opaque the data and analysis, the more inefficient are markets. Yet the climate-related risks and opportunities businesses face are currently shrouded in secrecy. Having information on such risks would allow investors to back their convictions with their capital, whether they are climate optimists or pessimists, evangelicals or sceptics. It would also permit corporates not only to meet investor demand for information, but also to position their businesses to win, rather than be left behind in, the transition to a low-carbon economy.”
The FSB report builds on other important work being done to re-design the plumbing to work in a way that channels funds to critical priorities and away from assets that deplete natural capital. The UN Environment Program launched their ‘Inquiry in to the Design of a Sustainable Financial System’ in 2014. Since then it has published its principle report on designing the financial system we need. This report recognises that the financial system will need to evolve to play its role in financing sustainable development and that environmental and social outcomes will be impacted by financial system development.
Whilst the financial sector has many flaws and failings as a system of capital allocation, they are not the biggest problem. That is one of demand, or more specifically, ‘considered consumption’. By this I mean that people are conscientiously thinking about what and how much they consume. I won’t get in to the detail of whether they make good, bad, ethical or other decisions as a result of that thinking — my brain is too small for that. I am going to place my faith in humanity that, generally, in the long run, we make pretty good decisions. I know, in the long run we’re all dead. And yes, I am perhaps being naïve or overly optimistic -that’s another debate.
Without considered consumption people don’t think about where their energy comes from; what environmental impact that burger had; how is their pension invested or what effect that extra doughnut will have when added to all the hundreds of other extra doughnuts they’ve had over the years.
You may think these things don’t matter but they do. They do because it is not all the flaws and failings of banks and banker that matter, it’s the plumbing as a whole. We could fix all those flaws and failings, metaphorical leaks that they are, but if people are still buying electricity from coal fired power stations or are allowing their pensions to be invested in fossil fuel projects; or they don’t care that an area of rainforest the size of their sitting room has been cleared to produce one burger, then we will have a leak free system still funnelling money to the wrong things.
Contrary to popular belief there are lots of good people in the financial sector who would be delighted to channel money to ethical pensions, clean energy and all sorts of lovely green stuff. But without demand coming from you and me, they simply can’t. Not least because they would effectively be investing in something no one is going to buy and this would not only be daft, it would also be contrary to the fiduciary responsibilities they owe to the owners of the money they are investing / capital they are allocating.