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«Global TrusT and EThics in FinancE Innovative Ideas from the Robin Cosgrove Prize Carol Cosgrove-Sacks / Paul H. Dembinski Editors Trust and Ethics in ...»

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Over the past thirty years, it has evolved from what was initially a limTrust and Ethics in Finance ited movement advocating morally informed investment decisions, to become an international industry worth over $2.7 trillion in assets. The current approach to SRI, while having clearly delivered tremendous benefits, creates a traditional dichotomy of the good versus the bad in the investment community at large. This not only limits the growth of SRI to a mainstream investment trend, but also hinders its application in emerging markets. As a result, it remains largely a developed-country phenomenon. Only an estimated $2.7 billion, or 0.1% of all SRI fund assets worldwide, are currently held in emerging market securities. Complexity of the application of ethics in investing in general, and in emerging markets in particular, needs to be acknowledged. While it is the socially responsible investment community and the development community at large that is interested in the sustainable development of EME countries, it is the mainstream investment community that is primarily concerned with maximisation of ROI.

Guiding money to where it is needed What is required, therefore, is for financial professionals to embark on an innovative approach to SRI, and focus on creating new frameworks and incentives to guiding money to where it is most needed. Two examples of this transforming framework approach have taken place in London. The first is the Enhanced Analytics Initiative (EAI), where asset managers and asset owners with over €380 billion assets under management are actively supporting better sell-side research on extrafinancial issues concerning society, the environment and corporate governance. They are committed to the individual allocation of a minimum of 5% of their respective brokerage commission to sell-side researchers who are effective at analyzing material extra-financial issues and intangibles. The second example is the Institutional Investors Group on Climate Change (IIGCC) who are helping investors to promote appropriate change in public policy to help address the climate challenge. This resonates with the new paradigm of ethical finance as described above: the The South and Carbon Dioxide 349 domain of business and finance ethics has shifted from legal concerns, to exploring what can be done over and above the law, to shape legal frameworks and incentives.

This new paradigm and new framework-changing approach to SRI needs to be applied to the challenge of increasing investments in sustainable SMEs in emerging markets to create more low-carbon highemployment societies around the world. And this ethics-first approach to deciding which ethical-financial issues to address is both the approach of the future and the most laudable one, because it truly embraces the responsibility that comes with the power of finance.

Size matters: the role of emerging market SMEs

The role of small and medium enterprises in emerging economies is now widely recognised. For instance in Africa, SMEs form the backbone of the private sector at all levels of development, and make a significant contribution to economic development in general and industrial development in particular. SMEs and the informal sector represent over 90% of businesses in Africa, contribute to over 50% of GDP, and account for about 63% of employment. Being labour intensive, SMEs absorb labour and other productive resources at all levels of the economy and flourish in villages, towns, and cities helping to develop technical

and business skills while reducing the rural-urban income gap. In addition, the following characteristics of SMEs make them particularly valuable for development goals (Luetkenhorst, 2004):

• SMEs are more labour-intensive. SMEs play an important role in generating employment and thus alleviating poverty, often providing employment opportunities at reasonable rates of remuneration to workers from poor households, and to women;

• SMEs contribute to a more efficient allocation of resources in developing countries. SMEs tend to adopt labour-intensive production 350 Trust and Ethics in Finance methods and thus more accurately reflect the resource endowment in many countries where labour is plentiful and capital is scarce;

• SMEs support the building of systemic productive capacities. They help to absorb productive resources at all levels of the economy and contribute to the establishment of dynamic and resilient economic systems in which small and large firms are interlinked;

• SMEs tend to lead to a more equitable distribution of income than larger enterprises. There is evidence that countries with a high share of small industrial enterprises have succeeded in making the income distribution more equitable. This, in turn, is a key contribution to ensuring long-term social stability by alleviation of economic disparities between urban and rural areas;

• SMEs are a seedbed for entrepreneurship development, innovation, and risk-taking behaviour and provide the foundation for long-term growth dynamics and a transition to larger enterprises. With the advent of globalisation, such linkages are of increasing importance whereby trans-national corporations (TNCs) seek reliable domestic suppliers for their supply chains.

The above-mentioned non-exhaustive list emphasises not only the importance of SMEs to emerging economies but also their tremendous relevance to the socio-economic and cultural context of many developing countries. Many researchers conclude that SMEs, more locally anchored than large corporations, are more likely to have ties of dependence and familiarity to their communities, which will ensure they protect their reputation and relationships among neighbours and customers. It is essentially through the promotion of SMEs that individual developing countries and the international community at large can make progress towards reaching the Millennium Development Goals of halving poverty levels by 2015.

The South and Carbon Dioxide 351

The trouble with being small

Despite the widely acknowledged importance of the SME sector, SMEs in emerging market economies face many obstacles, including corrupt governance structures, an unfavourable macro-economic environment, poor physical infrastructure, and a multitude of administrative challenges. However, inadequate access to financing continues to be one of the most significant impediments to creation, survival, and growth of SMEs. The most important factor here is risk: credit risk, currency risk and country risk. These are all higher for SMEs in developing countries and thus make the risk profile of emerging market SME funds too high for most ordinary investors.

As a result, private sector activity in many emerging market countries is hindered by a missing middle. While investors primarily focus on large firms (with over 500 employees), the development and microfinance communities are largely focused on very small businesses or micro-enterprises (5 or less employees). Furthermore, large enterprises and multinational corporations can exercise their influence in emerging markets to gain easy access to financing, whereas development and aid agencies primarily concentrate on the promotion of micro-enterprises.

SMEs (employing 10 to 100 people) find themselves caught between these two extremes. In many African countries, banks remain highly liquid and are reluctant to extend credit to other than the most creditworthy borrowers. While microfinance institutions have expanded vigorously, their limited scale remains largely insufficient for meeting the needs of many SMEs seeking start-up or growth capital. This leaves SMEs with little choice other than to seek the long-term risk capital that is crucial for starting-up or scaling-up their businesses. Moreover, SMEs also suffer from an image problem, particularly in the eyes of foreign investors. SMEs are often seen as being too small to serve as significant drivers of economic growth.

352 Trust and Ethics in Finance The difficulties confronting SMEs to finance their development mean that they do not have the required support to plan for the future.

Consequently investments in cleaner technologies and production processes, which only pay off after a period of use, are not affordable to many SMEs. This results in the SME sector in many countries not being as environmentally appropriate as it could be. With the anticipated growth in global carbon markets, with heavy polluters being paid to reduce their carbon emissions by using new technologies, SMEs could miss out, due to the very high transaction costs involved in administering the carbon credit process. This presents an opportunity to address the SME financing issue linked to an effort to green the sector, and thereby support more low-carbon jobs in emerging markets.

Meeting the challenge

Recognising the relevance of the SME sector to the growth of emerging market economies, a few innovative mechanisms have emerged that target the financial needs of SMEs. Initiatives include the East Africa Fund by the Shell Foundation and the Africa Enterprise Challenge Fund by the UK Department for International Development (DFID). While these initiatives are steps in the right direction, their focus is on a handful of African countries. Success of such initiatives is yet to be critically reviewed. Furthermore, no matter how successful such initiatives are, if the SME sectors in emerging economies are to be given a true boost, ways will have to be found for scaling up existing successful models. New mechanisms will have to be developed to either provide direct finance or to create conditions that enable SMEs to gain more ready access to finance.

Charity won’t work. A systemic approach is required that changes the balance or risks and incentives for ordinary investors, not socially responsible ones, so that more money flows towards sustainable SMEs.

The most important factor here is finding new ways of reducing credit, The South and Carbon Dioxide 353 currency and country risk at the same time as both screening and engaging SMEs to ensure that their activities are contributing to a low-carbon development pathway. Exploring the potential for what we call Risk Adjusting Philanthropy could solve this problem.

The potential of Risk Adjusting Philanthropy In the light of recent donations to charities by large banks dedicated to more traditional charitable activities, e.g. HSBC’s US$ 18.4 million funding of the WWF, large banks with strategic interests in growing the SME economy could make million-dollar philanthropic donations to a charitable organisation. The objective could be to set up a new foundation aimed at establishing criteria for sustainable enterprise, and certifying emerging market sustainable SME funds that meet specific criteria (there would be cascading criteria for the funds, the banks, and the SMEs themselves). This would drive improvements in SME practice as well as encourage entrepreneurship in areas such as clean technology and agro-ecology.

This new foundation would also:

• underwrite partial credit guarantees, in the form of a letter of credit, essentially guaranteeing reimbursement to investors of a certain percentage of any losses on the certified funds. This would reduce the risk profile of the funds and their ability to raise funds at a lower cost of capital i.e. attracting normal capital rather than socially responsible capital. If the funds were carefully identified then this foundation would not incur high losses, and could maintain or grow its assets over time;

• spend some of the interest earned from investments on reducing the insurance premium payments for the certified funds. The premium cost of political risk insurance can often make SME investment targets funds untenable (if you’re expecting a 5% Return on Investment (ROI), you can’t afford risk coverage costing 4% of the investment).

354 Trust and Ethics in Finance By reducing the cost of insurance this would make the funds more attractive to traditional investors;

• spend some of the interest earned from investments on supporting capacity-building in countries, through NGOs and local Chambers of Commerce, to promote the viability of sustainable SMEs. A key focus could be on helping to create credible carbon offset markets, so that SMEs could gain financially from investing in less carbonintensive energy production processes.

A new initiative with resources and experts is needed to explore this hypothesis, and other relevant ideas for the innovative financing of sustainable SMEs, and the public policy innovations that may be required for implementation. This would apply the new domain of ethics in finance, and the newest approach of SRI, to a key interconnected challenge of our time – promoting low-carbon high-employment economies in the global South. It would be satisfying for more of the world’s investors to care about the future of our planet and our children, but we believe it would not be ethical to rely on this in order to deliver the urgent changes required. Instead, if we create frameworks that enable investors to do the right thing, whatever their motivations, we are using our influence in the most conscientious possible way.

References Crane, A,/ Matten, D., 2003. Business Ethics: A European Perspective – Managing Corporate Citizenship and Sustainability in the Age of Globalisation, Oxford, Oxford University Press.

Luetkenhorst, W., 2004. Corporate Social Responsibility and the Development Agenda: Should SMEs Care?, UNIDO, Small and Medium Enterprise Branch.

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If we examine the lessons of the financial crisis, we can see that a system built on both trust and the rational value-maximising paradigm is fostering conflicts. The current situation therefore provides us with a unique opportunity to study the role of ethics in the financial system and to make concrete suggestions as to how to implement improved business codes of conduct. This article touches on two key areas in this development: the general public’s investments and the education of actors in financial markets.

After the storm

In the developed Western world, the preservation of fundamental aspects of human well-being sometimes seems to rank as peculiarly low

priority. The effects of non-monetary value are frequently disregarded:

success and prestige are typically associated with wealth. Environmental concerns are often ignored in favour of GDP And third world humanitarian catastrophes are likely to receive only the amount of attention from 356 Trust and Ethics in Finance the global community equivalent to their influence on the global economy.

The overlooked rationale is the fact that the values we feed into our systems, be they financial, social or environmental, are inevitably going to be reflected back at us with considerable accuracy. When we ignore the fragility of many of the ecological systems of our planet, the climate may change. When we neglect moral code and ethics in finance, the system may crash. The financial crisis did not happened to us as individuals much as it was created by us, if not by our direct actions then by our acceptance of the underlying set of values.

A major obstacle in quantitative finance theory is the theoretical simplification of the belief that more monetary wealth is always better.

This is the essence of the rational value-maximising paradigm. Qualities such as fresh air and human well-being are soft intangibles with no role in a quantitative financial model. At least that is the broad massage that come across in almost 50 years’ worth of modern finance literature.

Unless of course, some economical association can be made, such as risk management, public relations or avoidance of health-care expenses.

An emerging shift in social norms

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