The Financial Power of Impact Investing

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For many years the divide between instruments of philanthropy and investing has been clear cut. Investing strategies typically did not involve social organizations focused on non-governmental organization (NGO) concerns. However, the advent of millennial investing power, the rise of social enterprises, and the need for further asset diversification have blurred the line between both industries. Environment, Social, Governance (ESG) investing, informally known as impact investing, is on the rise with both active and passive investors. For example, ESG assets under supervision at Goldman Sachs have grown from US$3.8bn in 2015 to US$6.5bn end of fiscal 2016. As Goldman Sachs poignantly stated, ESG investing is now mainstream even within the pension fund and insurance sectors.

Even though financing social causes has overlapped between philanthropy and ESG investing, by no means is the latter non-profit seeking. First, while impact investing may dive into sectors once thought as solely philanthropic, let us make it clear that the investing strategies used to generate returns do not veer from tradition asset management practices. Specific return objectives are set, even if the companies that are in the portfolio may comprise all social enterprises. In fact, Goldman Sachs recommends that investors should be even more aggressive with risk/return analyses when it comes to ESG portfolios, to ensure even more accountability. Traditional sectors tend to put the bottom line first by nature, so it is of utmost importance to hold for-profit social enterprises accountable for revenue and profit estimates.

U.S. Trust’s “Impact Investing: A Guide To Doing Good While Also Doing Well” gives an excellent overview of impact investing. According to the U.S. Trust, managed U.S. assets committed to impact investing in total grew from US$640 billion in 1995 to US$6.57 trillion at present. Impact investing can be broken down into further categories of socially responsible investing (SRI), faith based investing, green investing, and values based investing (VBI). For example, an investor who is against tobacco use but is not necessarily pro-environment may seek investment in an SRI portfolio, but not a green portfolio. As with traditional ETFs and mutual funds, diverse social investing asset classes are available via equities, bonds, REITs and even private equity. Investment funds including these ESG options in have indeed increased from 55 to 925 within the last two decades. In particular, U.S. Trust’s ESG investor pool jumped 23% from 2015, with a whopping 93% of millennial investors who have added ESG components to their portfolios!

ESG investing is an excellent mechanism to be considered by shareholders through engagement and by Board of Directors through guidance and governance. Rick Scott, Vice President of Finance and Compliance at the McKnight Foundation, gave great insight as to the need for adding and monitoring ESG components to investment strategic directions at the Board level. The McKnight Foundation has allocated 10% of its US$2bn portfolio strictly to impact investing with a focus on US clean water and carbon footprint. Scott enlightens that the Board must call for a “triple bottom-line for financial, programmatic, and learning return.” Boards must have an investment or risk committee assigned to give oversight on risk/return objectives specific to the triple bottom line, and with C-Suite determine the healthy mix of ESG and traditional components for portfolio investments. We have said time and time again that clear internal corporate governance goals and procedures, in this case adopting a “triple bottom line” approach, is the most pertinent form of corporate social responsibility an organization can practice.

While global institutional investors have now become ESG investing stalwarts, retail investors, individual private investors, and minor shareholders may still need direction in how to effectively embark on the ESG investing journey. In addition, the ESG investing sphere has been known to be have quite a few ‘greenwashers’ with more public relations talk than actual profit generating. As with any investment vehicle, extensive research is recommended. Global investment firm Cambridge Associates has developed the Impact Investing Benchmark which comprises 51 private investment closed-ended funds dealing strictly with the intent to generate social impact. From this data, Cambridge Associates created and MRI Database, and uses ImpactBase extensively as well. U.S. Trust as well has developed benchmarks via an IMPACTonomics™ program, which has specific in-house and third party impact investing platforms such as the Breckinridge Sustainable Bond Strategies and IMPAX Global Environmental Markets Fund.

Many have the misconception that impact investing precludes investing in traditional industries, such as the fossil fuel and mining industries. Absolutely not! The smart and savvy investor must see diversification opportunity in line with tailored return objectives. There is financial power in such comprehensive asset management. The end point is return on investment, whether from most profitable traditional, social, and technologically advanced companies in the market. A gold mining company with a strong, proven corporate responsibility background can share the same portfolio as a profitable microfinance company that lends globally to small entrepreneurs. Again, the crux of investing in any asset class lies with return objectives. ESG investing, like smart technology, is no longer the niche market. As Rick Scott and Goldman Sachs put it, the point is to find the “right tools for the right time.” The time is right to consider impact investment vehicles in tandem with traditional market portfolios.

SOURCES

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Financial Policy Best Practice Framework

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On March 18th 2014 the US Federal Reserve Chair Janet Yellen stated the need for “reasonable confidence” in order to effectuate a more conservative monetary policy focusing on interest rate raise. Chair Yellen has indicated four macroeconomic factors that need to be further monitored.

  • The labor market with further unemployment rate decline;
  • A continued rise in currently slumped wages;
  • Core inflation stabilization (independent of energy ‘push’);
  • A higher “market-based” expected inflation rate.

The Fed’s decision to hold off on short term rate hikes comes one week after its macroprudential bank stress tests. Notable amongst the results was the “conditional approval” of Bank of America’s capital plan, with complete rejection of Deutsche Bank and Santander’s capital plans. It is clear that under Yellen the Federal Reserve is attempting to uphold the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. From a general standpoint, it is also quite glaring that the Federal Reserve as a central bank is fast adopting more of an eco-political role as a quasi-indirect financial system regulator through financial system monitoring. As has been mentioned before, monetary policy is the fastest mechanism to quell financial system defects, as fiscal policy results tend to lag.

Since the 2008 financial crisis, many economists have called for a more active regulatory role from central banks other than pure monetary rate fixes and being a lender of last resort. In January 2013 Fed Governor Powell met with members of the Financial Services Forum Policy Roundtable to the need for further engagement with appropriate bank regulators with regards to Dodd-Frank and specific cooperation among federal banking agencies. Here we see the Federal Reserve’s role expand into embracing full regulatory responsibilities and acknowledging the need to be more cognizant of fiscal agency activities. Since it is fast becoming the trend of the US Federal Reserve and of central banks in general to take up more than pecuniary monetary policy functions, it is the responsibility of the Financial Policy Council to suggest optimal regulatory best practices.

After careful examination, we found great quantitative insight in regards to the prevention, control and monitoring of financial crises by central banks through the International Monetary Fund’s Policies for Macrofinancial Stability: How to Deal with Credit Booms. (Giovanni Dell’Ariccia, Deniz Igan, et al. 2012). As the title suggests, credit booms are cited as the main, very complex cause of large scale financial crises which mere shifts in short term interest rates cannot fully solve. It is important to note that credit booms are intrinsically not detrimental to the financial system and to the macro economy at large, once properly and timely monitored. The tail risk associated with credit booms can bring strong growth or absolute demise to the financial sector depending on how it is mitigated during the boom, and controlled for the expected credit trough cycle. While there is increased regulation of the overall banking sector within the US, there is a renewed tendency towards credit increase within the non-banking business sectors, which in turn spur the banking sector to increase product (mortgage) marketing to remain competitive. This is a structural aspect of the financial system which encourages credit booms, and credit crises within the US.

Credit Boom Identification

  • The IMF defines credit boom as any period during which the annual growth rate of the credit-to-GDP ratio exceeds 10 percent. A boom ends as soon as the growth of the credit-to-GDP ratio turns negative; thus, the credit-to-GDP measure for any sovereign is crucial to monitor by the Federal Reserve, even in the resetting of an indirectly related short term market shocks.
  • Dell’Ariccia and his IMF colleagues applied the definition of a credit boom and ensuing variance stress tests to a sample of 170 countries with data starting as far back as the 1960s and extending to 2010, with the identification of 175 credit booms therein.
  • One of the most telling results of sample testing showed that no matter the country classification or geographical sphere, one in three booms was followed by a banking crisis within three years of the boom. As well, the IMF results showed that the geographical regions that experienced credit booms had even greater credit delinquency during and well after the crises.
  • Three out of five booms were followed by subpar growth in spite of further macro economic stimulus packages for at least six years following the credit contractions, or outright credit busts. The referenced term for this phenomenon is a “creditless recovery.” One very strong contributing factor to this type of recovery is a failure of both monetary and fiscal policy to focus on credit aggregates, and instead silo industries and sectors according to individual need (e.g. Real Estate).
  • An even more concerning find by the IMF study showed that credit booms generally start at the tail end or after buoyant economic growth. Many decision makers in the lower federal or parliament house tend to believe a credit boom is an absolute sign of economic growth. This is not necessarily so. In many cases, a credit boom occurs to make up for declining economic growth, depending on the sovereign’s liquidity position.

Monetary Policy Control

In particular, credit booms seem to occur more often in countries with expansionary macroeconomic policies, and low quality of banking supervision. This model usually fits a developing country or emerging market paradigm. Thus, it is noteworthy that the major financial crises of 2008 stemmed from the US banking and financial systems, and even more so from a primarily credit risk perspective. It is as if the central banking system completely dismissed signs of macroeconomic overheating. Should monetary policy then remain conservative with high cost of borrowing, low asset price valuations to stifle credit growth? The answer goes both ways. Most times central banks focus on short term rate adjustments to adjust money supply, all the while paying attention to market risk. This was the case of the US Federal Reserve prior to the financial crisis of 2008. We have already pled the case for allowing a credit boom to occur, with control. A credit boom naturally has credit risk to adjust for; therefore it is necessary for central banks to change monetary policy in response to aggregate asset price. We note here that aggregate asset price valuation control is necessary over a focus on individual bank institutions to effectively mitigate credit risk factors.

A serious problem faced by central banking decision makers is tightening monetary control during the first sighting of a credit boom, as purely political decision makers may confuse a credit boom with absolute economic growth. Monetary policy measures to control a credit boom can spur a higher short term unemployment rate, which leads to fiscal issues. Well meaning monetary policy control can also exacerbate macroeconomic pressures: increases in rate borrowing costs can lead to an outflow of funds to foreign lenders, even more creative variable interest only lending options, and a further increase in the banking sector’s debt service.

Almost all sovereigns immediately turn to monetary policy unsupported by immediate regulatory policy to ‘fix’ the repercussions of a credit decline, credit bust, and ensuing financial crisis, since monetary policy does have the ability to create corrective action without an extensive time lag. The IMF study states that stand-alone monetary policy can help slow down a credit boom during economic overheating, or simply put, when the economic crisis hits. However stand-alone monetary policy is still reactive without the support of immediate macro prudential regulatory policy, with a policy framework considering aggregate changes.

Fiscal Policy

Fiscal policy has the least immediate positive effect on immediately controlling credit booms. Fiscal policy counts in the long term outcome of controlling the likelihood of credit booms through resetting tax provisions that affect borrowing. The IMF study cites that fiscal consolidation independent of a credit boom can bolster the financial sector in case of a credit crisis. However, the time lag and political implications associated with fiscal policy are inhibiting factors to a proactive control at the early stages of a credit boom. This brings to question the overall effectiveness of governmental fiscal policy in an ever changing and increasingly sophisticated global financial arena. Empirical support from the IMF study suggests that fiscal tightening is not associated with a reduced incidence of credit booms that lead to financial crises in the short to medium term. If so, it may be quite precarious to place increased financial system decision making in governmental folds.

Dell’Ariccia and his IMF colleagues propose countercyclical taxes on debt to offset the credit cycles, and so add tightening balance during a credit boom. In this regard, there will be further fiscal consolidation, or “buffers” that may act in the same manner as a regulatory capital requirement. A salient point made in favor of this measure is that the taxation would apply to the very active nonbank financial institutions as well. The issues cited with such fiscal policy modifications have to do with an easy circumvention of tax policy through various “tax planning” mechanisms especially employed by the nonbank sectors. Indeed, the IMF regression results actually depict that during a period of high economic growth, increasing tax revenues are simultaneously correlated with an increase in credit lending by both bank and nonbank entities. Further taxation may then truly be counterproductive to financial system tightening.

Regulatory Policy

Macro prudential policy consists of capital and liquidity requirements, and regulatory stress testing of the banking sector throughout the economic cycle. Capital and liquidity requirements act as countercyclical buffers to control the cost of bank capital; loan-loss provisions especially demand capital increases to account for an economic trough. When put into practice in a consistent manner, regulatory policies provide adequate information to decision makers on the credit health of the banking sector. To date, most of these policies have been fully monitored and implemented in hindsight as it pertains to curtailing and preventing a credit boom. Regulatory policy as a stand-alone has not been fully effective with curtailing the start and duration of an overheating credit boom.

Aggregate measures of macro prudential policy include the following:

  • Differential treatment of deposit accounts;
  • Reserve requirements;
  • Liquidity requirements;
  • Interest rate controls;
  • Credit controls;
  • Open foreign exchange.

The IMF team found through empirical analysis that these measures are truly helpful in predicting a negative outcome of a current credit boom, rather than being able to actually prevent credit overheating in the financial system. The IMF also found that the global banking sector has been able to circumvent credit controls such as asset concentration by utilizing foreign partner or parent banks, and/or by creating foreign banking and nonbanking spinoffs. Empirical analysis also suggests that the Loan to Value (LTV) ratio monitoring is particularly prudent in restricting negative credit overheating, especially when faced with real estate credit crises.

Conclusion

The IMF study suggests and we agree that financial policy is justifiable in preventing, curbing and monitoring credit overheating in the global economy. We also see that stand-alone policies are not fully effective in mitigating negative credit and tail risks with the boom. Overall, a credit boom occurring during an economic boom can have positive returns once aggregate risk is effectively managed. Since the 2008 financial crisis we see the US Federal Reserve take a more active role in setting financial system policy monitoring, which in effect may be necessary given the highest stand-alone weakness of fiscal policy. Suggestions are as follows:

  • When credit booms coincide with a general economic boom, monetary policy can be the initial (not sole) tool to manage and slow down economic overheating.
  • During the early stages of a credit boom, macro prudential and other regulatory policies should be effectuated in line with monetary policy to ensure capital buffers to mitigate a credit crisis.
  • The IMF has stressed that the governing body to enforce macro prudential polices must have a thoroughly structured task force to supervise and detect when capital requirement thresholds are triggered on a case basis and in the aggregate.
  • More than half of credit booms examined that started at an initial credit-to GDP ratio higher than 60 percent ended up in crises. This ratio needs to serve as a primary quantitative credit risk trigger for central banks and federal agencies.
  • Fiscal policy falls short in curbing credit overheating in the short term, even when coupled with monetary or macro prudential policies. Fiscal policy providing tax code provisions to limit borrowing can bolster the overall health of an economic boom, but possibly may not aid in curbing a specific credit overheating.

As global markets become more sophisticated and fast paced, we see the need for central bank decision making for the financial system, which entails a marked focus on credit risk and macroeconomic indicators. We expect to see the US Federal Reserve and central banks in general employ a well structured mix of financial policies to manage credit booms, mitigate associated risks, and turn around “creditless recoveries” into long term economic stability.

SOURCES

Giovanni Dell’Ariccia, Giovanni, Igan, Deniz et al. “Policies for Macrofinancial Stability: How to Deal with Credit Booms.” The International Monetary Fund Staff Discussion Note. June 2012.

Matthews, Steve. “Yellen Is Watching These Four Indicators for Signals on When to Raise Rates.” Bloomberg Business Online. March 2015.

The US Federal Reserve Regulatory Reform. “Resolution Framework.” The US Federal Reserve Online. March 2015.

Van den end, Jan Willem et al. “The Interaction between Central Banks and Government in Tail Risk Scenarios.” De Nederlandsche Bank Working Paper. March 2013.

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Why Financial Education?

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It is a sad fact today that most people starting with students are financially illiterate.

Here are some sobering facts:

  • The average score on a freshman “financial literacy exam” was 59%, according to the JumpStart Coalition.
  • The average student has roughly $23,000 in student loans, $4,000 in credit card debt and four credit cards.
  • An average of 7% percent of graduates default on their student loans within the first few years.

Here’s what students are begging to understand:

  • 84% say they need more education on financial management, according to Sallie Mae.
  • 62% say their knowledge of credit reports is either fair or poor, according to the Consumer Federation of America.
  • 60% have only a vague understanding of their debt, according to TheFreeLibrary.com.

So what can we – as parents, activists and educators do?

Start talking

Dedicate a portion of your time with your children and financially illiterate friends to money. Encourage them to share their struggles and successes. They like hearing from one another. They trust each other. Because people generally aren’t as comfortable talking about money as we are other topics, it’s important to foster these important discussions. Pushing people to get outside of their comfort zone will make the experience more memorable and more effective in their drive toward financial independence.

Bring problem-solving to the discussion

Feeding young and even older minds financial facts does little to increase financial intelligence. The trick is engagement. Researchers from the JumpStart Coalition found that financial literacy is really a measure of problem-solving ability rather than a mere awareness of financial facts.

Establish and nurture identity

It is a fact that when you lose your identity, you stall growth. You face closing doors. You lose freedom. The same is true for financial identity. Most people don’t know how to effectively budget, manage their debt loads, or save. If they’re lucky enough to find jobs, they face starting salaries that have remained stagnant for more than a decade. Yet, if they can learn the basics of money management and problem-solve their way out of sticky financial situations, to be their own financial advocates, and learn where to get help they’ll be more likely to find success.

Bottom Line:

Most of us are not doctors but know what to do to take care of our health. We get this knowledge from our parents, peers, our regular reading, TV etc…. We try as far as possible to follow the advice on balanced diet, Exercise, rest, and minimize/ eliminate bad habits like smoking and drinking. I would like to think of “financial education” in the same way. We all need money to ensure a good life and we need to take care of it. You don’t have to be a mathematics or financial genius to understand this. Here are my basics:

  1. Live within your means. Ensure you can pay for what you buy.
  2. If you borrow money ensure you can pay the EMI. Check to see if you can still pay for it if interest rates were to rise/ you were to lose your job.
  3. Protect what you have. Insure your life, Health and assets. You wouldn’t leave your house unprotected, don’t do it with your life or health.
  4. Plan your future expenses like child education, buying a home, Retirement etc….. See how much you need and save accordingly. There are plenty to tools that will give a good estimate of what you need.
  5. Inflation would eat into your savings, so invest in something that will give a long term return higher than inflation.
  6. Last but most important. Stay away from get rich quick schemes. Getting a good physique is a long term & constant effort, so is accumulating wealth. Get rich quick schemes are like steroids they will do more harm than good.

Most people can understand and follow these rules. Of course you may need advice from professionals from time to time, but subject the professional advice to test of reason ability. If the advice is too good to be true, it probably is.

Share your thoughts…

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Central Banks: A Question of Governance

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Fiscal year 2015 is upon us, and is fast becoming the year of historic monetary policy changes in light of an appreciating US currency and, in turn, a blanket decrease in European and Asian economic growth.  Since late 2014 and in full swing 2015, the Danish central bank, the Swiss National Bank, and  the Bank of Russia cut key interest rates, with probable Turkish Central Bank short term rate cuts to follow. The Bank of China has recently reduced its requirement ratio as well to encourage growth. In the US it is expected that the Federal Reserve raise short term rates by mid-year 2015, a policy change that has not been effectuated for over three years. It is apparent that governments are depending heavily on central banking to modify economic growth patterns as a short term solution.
While the spotlight is fixed firmly on central bank monetary policy to control the global economy, should central banks be fully responsible for financial stability? From a governance perspective, central banks act first and foremost as an independent or fully state-run agency to ensure adequate capital liquidity.  The gist of central banking is to control the effects of growth expansion or decline, and not necessarily to be the institution to structure economic growth itself. In addition, one of the tenets of central banking is to oversee a sovereign’s commercial banking system, and be thus supported simultaneously by government legislature.
If this foundation of central banking was kept constant, we would not have had such financial turmoil in 2008. However, lack of commercial bank corporate governance due to lobbying influence has vastly undermined central banking effectiveness in the long term.
In layman’s terms:

  1.  Short term upon short term upon short term monetary rate fixes does not equal proper long term decisions. Decisions that should be made with no biased influence from legislature.
  2. The global monetary system has moved from fully secured to almost totally unsecured asset-backing over the past 40 years. Most world currencies are much less asset-backed than ever before.

Both very simple reasons listed above explain why at anytime an industry receiving the most ‘creative’ cash flow (derivative upon derivative) will experience the dreaded bubble. And, while it is natural in the scheme of a global economic cycle to have peaks and troughs, the mass non-collateralization of currencies, followed by a now endemic financial culture of sophisticated derivative creation leads to unsustainable growth. It’s less long term growth and more adrenaline rush. We have more monetary policy magicians at work than real doctors of the art.
The Bank for International Settlements examined the central bank’s role in being the overseer of global financial stability in its May 2009 publication, Issues In The Governance Of Central Banks. The article points out that while central banks are needed for monetary stability, having the central bank be the main institution for overall financial stability gives unwarranted responsibility, and unnecessarily overlaps with government functions:
Governance arrangements for the financial stability function are generally less settled than for the monetary stability function…apart from the lender of last resort function and various regulatory powers, there are no central bank policy instruments that are uniquely suited to ensuring systemic financial stability. Instruments that might influence financial stability have other primary roles…Using such instruments for ends other than their primary purpose inevitably involves trade-offs.
It is therefore ill-advised policy to depend solely on the central banking model for ongoing global financial stability. Yet, from a governance perspective can individual banks be allowed full deregulation? Deregulation makes sense in a free market economy. However, judging from the shenanigans of 2008, we need checks and balances in our global banking system. In the US, bank regulation took a dive in December 2014: Section 716 of Dodd-Frank financial law, which would have forced big banks to keep their derivatives mostly separated from their insured deposits, was repealed by the U.S. Congress, with planned repeals to follow in FY2015. Can a global economy with rampant recession afford the repercussions of a huge financial crisis within the next two years? Probably not: short term policy issued by a sovereign’s central bank cannot fully override financial policy decisions made by legislature, based on corporate influence.

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My Personal Reflections on Davos 2015

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In just a matter of years, we’ve seen the digital revolution transform business, politics, media and society right across the world.

The Davos fest early this year only confirms the trend where this revolution is clearly driving a shift from ‘old’ to ‘new’ power in the world.

A new power’ world characterized by a shift away from unthinking consumption to people being ever more involved in creating, sharing, funding and owning products, services and ideas.

Where old power business models are defined by what one company has that others haven’t, new power models are renewable because they are driven by the passions and energies of the many.

Take a close look at Bitpay and Blockchain, both shaking up the banking industry by giving more people access to a new currency in a secure way, without the permission of governments and institutions…. Along with Sidecar with their true marketplace experience challenging Uber and Lyft to get people moving.

Although new power doesn’t necessarily mean for the better, I think the shift will force old power models to adapt and will most importantly lead to interesting collaborations between old and new power models.

What are we to make of all of this?

I believe the battle ahead, whether you favor old or new power values, will be about who can control and shape society’s essential systems and structures.

Let’s face it, many of our systems need a real shake up. Why wouldn’t you upload the power and talent of billions to do it?

Do we have what it takes to make it happen?

Well I certainly hope so because if you had to reflect on Davos’ recent gathering of world leaders, I am afraid the mood this year was more pessimistic than in 2014, when the euro zone seemed on track to recover from its deep financial and economic crisis. Since then, a range of geopolitical risks have surfaced and growth in Europe has stalled.

Further, reviewing the global economic outlook at the Conference, speakers from the IMF, the ECB, the Bank of England and the Bank of Japan said their ultra-loose monetary policy could only buy limited time for politicians.

My hope is to see word leaders not succumbing to pessimism over the state of the world economy.

A year before, no one had foreseen the fall in the oil price, which has dropped more than 50 percent and reached levels last seen during the financial crisis.

While producer countries in OPEC and beyond were suffering, much of the world could benefit and develop.

In fact , I believe the plunging price of oil and gas provides a once-in-a-generation opportunity to fix bad energy policies.

We just need confidence and less uncertainty and focus on “transitioning growth” from consumption to investment.

Share your thoughts….

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