What is finance for?

Jonathan Watson, IBA Finance CorrespondentWednesday 12 August 2020

The need to rebuild and renew economies after the devastating effects of the Covid-19 pandemic ought to accelerate the finance sector’s attempts to rediscover a sense of purpose.

Ask people what the purpose of the financial sector is, and more often than not you’ll get the answer: ‘making lots of money.’ After the financial crisis of 2008, there was an opportunity to change that. It wasn’t taken.

Politicians and policymakers decided to restore the past, rather than look for a different future. In terms of financial regulation, they did try to come up with a better version of the past. But everything else was to stay the same.

Mervyn King, Governor of the Bank of England when the crisis hit, used the Per Jacobsson lecture he delivered at the International Monetary Fund last year to admit that the response to the crisis had not achieved the desired effects. ‘A decade ago, we thought the banking crisis was over – with the recapitalisation of the largest global banks – and that the recovery already economies would soon spread to the industrialised world,’ he said. ‘That recovery has proved frustratingly slow, and no sooner do we think we are on track to “normalise” than new obstacles appear.’

Since the immediate bounce back from recession in 2008–09, there has not been a single year in which the world economy has grown. This is at least partly due to a lack of new thinking, King said. ‘Following the Great Depression, there was a period of intellectual and political upheaval,’ he said. ‘No one can doubt that we are once more living through a period of political turmoil. But there has been no comparable questioning of the basic ideas underpinning economic policy. That needs to change.’

The shock of the Covid-19 pandemic has multiplied that turmoil tenfold. Industry players and regulators have been forced to think, once again, about what economics and finance are for. Perhaps now is the time, as we start to think about how to ‘build back better’ after the dramatic economic impact of the pandemic, for banks and others to rediscover a sense of purpose.

What’s the point?

Not everyone agrees this is a good time to confront the big issues. For many, the key priority is simply getting back to work. ‘Business as usual’ feels reassuring following the trauma of the pandemic.

At the British Academy’s ‘Future of the Corporation’ event in June, Microsoft Chief Executive Officer Satya Nadella was challenged on this point. Should purpose be off the agenda for now? He thought not. ‘If anything, it’s time for us to revisit the social purpose of companies,’ he said.

Before the pandemic, the Academy published a new definition of the purpose of the corporation as part of its Principles for Purposeful Business. Companies are, it said, ‘to profitably solve the problems of people and planet, and not profit from creating problems.’

There is a shift in societal expectations about what businesses do, says Jeff Twentyman, a corporate and M&A partner at Slaughter and May and Co-Chair of UK Stakeholders for Sustainable Development, a multilateral association that works to deliver the United Nations Sustainable Development Goals in the UK. There’s now an assumption that firms need to think beyond the traditional mantra of delivering for shareholders. ‘Every chief executive has opened his Covid response speech by saying the company’s priority is to look after its employees and its customers,’ Twentyman says. ‘That’s a shift away from shareholder primacy to a more stakeholder-driven model.’

Danone, the French food multinational company, has used the Covid-19 crisis to accelerate its transformation into an ‘entreprise à mission,’ with long-term social and environmental goals. Inspired by the benefit corporations, social purpose corporations and public benefit corporations that exist in the United States, this is a new type of corporation created in France by the ‘PACTE’ law. The Action Plan for Business Growth and Transformation mandates ‘companies do more than simply seek to make profit. The PACTE will modify the Civil Code in order to assert their social and environmental role and provide them with a true raison d’etre.’

As a first step, just some recognition of the need to achieve a fairer division of existing wealth would be reassuring

Luke Hildyard
Executive Director, The High Pay Centre

Adopting this model formally commits Danone to going beyond the traditional corporate focus on short-term profit maximisation. The firm also pledges to prioritise other stakeholders such as workers, community, environment and customers.

In June, shareholders overwhelmingly approved the plan. It means the firm has to articulate a public purpose and create an independent supervisory body to monitor its performance against that purpose. ‘You’ve just toppled a statue of Milton Friedman,’ the company’s CEO Emmanuel Faber told them.

Faber, who is presumably aware Friedman co-authored a book titled Tyranny of the Status Quo expects the commitment to more responsible business – to environmental, social and governance (ESG) criteria – to make the company more resilient both during and after the pandemic.

According to Twentyman, research suggests that companies with a higher ESG quotient have coped better with the Covid-19 crisis because they already have a focus on resilience and their stakeholders. ‘They’ve been better placed to respond to this,’ he says.

In the UK, the Corporate Governance Code now requires companies to articulate a corporate purpose. ‘The board should establish the company’s purpose, values and strategy, and satisfy itself that these and its culture are aligned,’ it says. ‘All directors must act with integrity, lead by example and promote the desired culture.’

The role of finance in a Covid-19 world

The notion of ‘build back better’ has been driven by the sustainability movement, says Twentyman. ‘It basically means “please don’t just invest to take us back to where we were before, because where we were before was deeply flawed.” We have to invest in things that we need to do and invest to accelerate the things that we all knew we needed to do.’ It’s a mantra for a green, sustainable recovery.

This is where finance can play a major part. As former Bank of England Governor Mark Carney has said, rather than the financial sector being the core of the problem, as it was in 2008, now it can be part of the solution. And clearly Carney is willing to both talk the talk and walk the walk: on departing the Bank of England, he took up the position of UN Special Envoy for Climate Action and Finance. The finance sector was already beginning to get the message about sustainable investing and the pandemic is likely to inspire an acceleration of this trend.

‘Sustainability in a broad sense is becoming very important,’ says Hendrik Haag, a banking supervision and financial market regulations partner at German law firm Hengeler Mueller, who chaired the IBA Task Force on the Financial Crisis. ‘There have been very mild attempts at a supranational level to agree on carbon dioxide reductions, but these are negotiations between states that go very slowly. What we see now is that the financial world agrees in one way or another to stop supporting industries that have a significant carbon footprint. This is a very powerful tool. It’s global leverage politicians can only dream of.’

Build back better basically means, please don’t just invest to take us back to where we were before, because where we were before was deeply flawed

Jeff Twentyman
Partner, Slaughter and May, and Co-chair, UK Stakeholders for Sustainable Development

In Europe, the European Commission is attempting to guide the process. At the end of March, the Commission’s expert group on sustainable finance published its final recommendations on the EU Taxonomy, a framework for classifying green investments. The Commission describes it as ‘a tool to help investors, companies, issuers and project promoters navigate the transition to a low-carbon, resilient and resource-efficient economy.’

According to Silke Goldberg, a partner at Herbert Smith Freehills who specialises in energy law, the EU Taxonomy hit people’s desks just as they were thinking about what the coronavirus means for the future of their business. ‘This means that the focus on ESG, which was there pre-Covid-19, has amplified,’ she says. ‘The Taxonomy will affect financial products and services, as it determines how they can be classified as environmentally friendly or sustainable. It means that in the EU, the ESG label will have a legally binding reference framework.’

Many banks were already ‘decarbonising’ their loan portfolios. Dutch bank ING, for example, said in 2018 that it would be steering its portfolio in line with the goals of the 2015 Paris Agreement to keep global warming to well below two degrees, with the ambition of aiming for 1.5 degrees. The bank calls this strategy the Terra approach.

‘With economic asset-level data and climate scenarios at its heart, the approach piloted by ING, together with 20 other banks, creates an understanding of the relationship between financial transactions, the real economy and climate goals,’ says Jakob Thomä, Managing Director of the 2° Investing Initiative Network. This is a think tank that works with ING on Terra. ‘It reaffirms that – in the words of Henry Ford – the highest use of capital is not to make more money, but to make money do more for the betterment of life.’

BNP Paribas claims to have been carbon neutral on its operational scope (direct greenhouse gas emissions and indirect emissions linked to the purchase of energy and business travel) since 2017. And since 2012, the group has led an active policy to reduce its CO2 emissions through measures to improve energy efficiency at its buildings and data centres, and through optimising professional travel.

Standard Chartered bank announced its first coal exclusion policy in 2016, and in February 2020, launched $35bn of project financing, advisory and debt structuring services for solar and wind projects.

Even Barclays, which provided $85bn in funding to fossil fuel companies between 2016 and 2018, recently said its ambition was to become a net zero bank by 2050. It has committed itself to aligning all of its financing activities with the goals and timelines of the Paris Agreement.

The pivot that perhaps gained the most attention was performed by BlackRock. The fund manager unveiled sweeping changes in January 2020 in a bid to position itself as a leader in sustainable investing after criticism that the company had failed to use its clout to help combat the climate crisis.

Time to unpick conflicts of interest

Many governments have already had to think about insolvency during the Covid-19 crisis. In the UK, Parliament has already adopted a new law, the Corporate Governance and Insolvency Act 2020, that combines temporary measures to deal with the pandemic with permanent changes to insolvency law.

There could be further action. Some have argued that the insolvency process itself suffers from a systemic problem. The All-Party Parliamentary Group (APPG) for Fair Business Banking, originally founded to look into interest rate swap mis-selling, has called for a fundamental overhaul of insolvency regulation after a series of misconduct cases centred on conflicts of interest between banks and insolvency practitioners.

While insolvency practitioners are essentially self-regulated, most of their work comes from the banks, says APPG member Kevin Hollinrake MP. This creates an ‘unholy alliance’ whereby insolvency practitioners are reluctant to criticise banks even if they have been at fault when a business goes into administration.

There is a similar issue in the audit market, where the ‘Big Four’ accounting firms – PwC, Deloitte, EY and KPMG – have been told to split their audit units from their advisory arms. Consulting is more lucrative than accounting, but it also encourages auditors to avoid any negative feedback that might jeopardise their firm’s consulting opportunities.

UK audit regulator the Financial Reporting Council (FRC) recently published a review of a number of audits. It concluded that one-third of the reviewed audits carried out by the country’s seven largest firms were not good enough. ‘Firms are still not consistently achieving the necessary level of audit quality,’ the FRC report said.

The Council’s experts were particularly unimpressed by PwC, KPMG and Grant Thornton. These firms have already been criticised over their involvement in high-profile corporate failures at Thomas Cook, Carillion and Patisserie Valerie.

The FRC itself has come under fire in recent years for being too soft on auditors. It is soon due to be abolished and replaced by a new regulator, dubbed the Audit, Reporting and Governance Authority.

The firm pledged to double the number of sustainability-focused exchange traded funds it offers to 150.

It also promised to cut companies that derive a quarter or more of their revenues from thermal coal from its actively managed portfolios, as it aims to increase its sustainable assets tenfold from $90bn today to $1tn within a decade.

The changes were unveiled alongside CEO Larry Fink’s annual letter to chief executives, in which he said climate change had become a defining factor in companies’ long-term prospects. ‘I believe we are on the edge of a fundamental reshaping of finance,’ he said.

‘If BlackRock says it’s not going to buy bonds from anyone involved in coal or gas burning, that’s very powerful,’ says Haag. ‘That is the most important trend that could change things. It really puts pressure on companies that want to maintain affordable financing terms to follow what their investors are looking for.’

For now, he says, the margin difference between green and non-green finance is still very small. However, this will change. ‘If you are a coal miner, your bond rates will go up compared to other industries. And that will spread from green to other ESG criteria. If firms want to say they have a mission that’s fine, but they will be judged by what they do and how they do it, rather than what they say. Investors are more and more opinionated on these issues and that’s going to be a very interesting trend.’ Twentyman agrees. ‘The financial industry is doing a lot, because it has a lot to do,’ he says. ‘The big growth area in asset management is people wanting high sustainability quotient investment opportunities.’

Investing in sustainable business is not just the right environmental decision – it’s the right commercial decision as well. BlackRock said in a research note published in May that 88 per cent of sustainable funds did better than their non-sustainable counterparts in the first four months of 2020. Those same 32 indexes, which BlackRock says are widely used and represent the global market, also performed better than their traditional counterparts during declines in 2015–2016 and 2018.

Better incentives

Another way that finance could show its commitment to building back better is by rethinking executive pay. ‘Executive remuneration should be aligned to company purpose and values, and be clearly linked to the successful delivery of the company’s long-term strategy,’ says the UK Corporate Governance Code. That is not a phrase many people associate with finance. In 2019, 751 staff at the Royal Bank of Scotland (around one per cent of its total workforce) were paid £327m.

However, this year, for the first time, UK listed companies are required to publish ‘pay ratio’ data in their annual reports. This must show the total earnings of the company’s CEO compared to the individuals at the upper, median and lower quartiles of the pay distribution of their UK employees. The High Pay Centre, a think tank, has analysed these disclosures in annual reports that were published between 1 January and 30 April this year. A quarter of the reports came from financial services firms.

If anything, it’s time for us to revisit the social purpose of companies

Satya Nadella
Chief Executive Officer, Microsoft

It found that the median gap between the CEO and the lower quartile threshold of the pay distribution was 78:1 for all companies in the sample, while for the larger Financial Times Stock Exchange 100 companies it was 109:1. This means that these CEOs are making more money in under four days than a quarter of their colleagues will earn in an entire year.

‘The truth is that measures that can turn the hypothetical redistributions identified in our research into reality are integral to hopes that we can ‘build back better’ in the aftermath of the pandemic,’ says Luke Hildyard, the centre’s Executive Director. ‘Specific policies could include better workplace access for trade unions; business governance reforms to give workers more say in corporate decision making; and much wider provision of all-employee share ownership or profit-sharing schemes. But as a first step, just some recognition of the need to achieve a fairer division of existing wealth would be reassuring.’

The financial world agrees to stop supporting industries that have a significant carbon footprint. This is a very powerful tool. It’s global leverage politicians can only dream of

Hendrik Haag
Chair, IBA Task Force on the Financial Crisis

Some financial firms could also find themselves caught up in debates over state involvement in national economies after the pandemic. After the financial crisis, it seemed clear that the governments would have to play a much larger role in the management of financial institutions. That didn’t really happen.

Covid-19 has wrought such economic havoc that the state is being forced to assume hugely increased responsibilities. Governments are having to rescue companies from all sectors. There are still concerns about banks in the southern countries of the EU, some of which still have a significant amount of defaulted loans on their books. ‘That’s going to get worse as a result of the Covid-19 crisis, especially in Italy,’ says Haag. ‘Once in a while, we still have the idea that we need a fresh start for the banking system. We could recapitalise the banks, like in the US after 2008 where banks were forced to take state money, accept the state as a shareholder, carry out a recapitalisation and then try to re-privatise. The idea is worth considering, as progress in Europe has been very slow. The recovery effect in the US was much quicker.’

A fresh start would certainly be welcome. In a recent survey conducted by polling firm YouGov, only six per cent of people said they wanted things to go back to how they were before the coronavirus crisis. If the finance sector can rediscover a sense of purpose and commit to building back better, they won’t have to.

Jonathan Watson is a journalist specialising in European business, legal and regulatory developments. He can be contacted at jonathan.watson@yahoo.co.uk