The financial crisis could boost responsible investment, provided it can get its act together first

The current financial crisis provides a unique opportunity for responsible investment.

This sounds hard to believe for the investors in niche funds focusing on environmental, social and governance issues who have suffered heavy losses in recent months. They might even be tempted to move their money into more mainstream vehicles, which might be perceived as safer.

The current market turmoil, however, could have a positive outcome by making investors of all stripes rethink the purpose of investment. Burned by falling stock prices, asset owners and managers will start to question the value of strategies pursued in recent years. In doing so, they may find that chasing returns has not served them, or the clients, very well.

The responsible investment movement has always emphasised that the purpose of investment is to pick sustainable, productive businesses that generate solid returns for shareholders over the long-term. This notion of investment has not been popular in recent years, but now it seems its time has come.

A decade of rising asset prices caused investors to get overexcited at the prospect of short-term gains. Investors rewarded companies that hit the numbers. They supported banks that geared up their balance sheets to become more profitable. Regardless of the risks, they sanctioned the business models of now failed mortgage banks that relied on wholesale funding to finance their lending. A lack of transparency was not the problem; boundless faith in an endless supply of cheap credit was.

The current crisis shows that a healthy economy depends on making sure that capital is allocated to companies that are productive, successful and sustainable. In the long term, businesses that understand a wide range of risks, including social and environmental ones, and have good relationships with their stakeholders, will be in a better position to do this. The object of investors should be to identify these firms so that they can prosper as they do.

So could responsible investment help avoid another credit crunch? The problem for advocates of this view is that ethical investors were no better placed than their mainstream counterparts to identify the risks that caused the current turmoil (see special report).

The handicap of most SRI funds is that they are not financially-minded. Too often they overlook core business activities because they do not understand them. The current SRI model seems to be to identify a set of “ethical” issues, then cross-check them against a list of companies. Where those issues are found to be significant, or material, for a company, the fund starts to engage with it.

Instead, funds should start by analysing the core business activities of companies in which they are planning to invest. Working from a knowledge of how the business works, and not a hit-list of ethical issues, would ground their investments in reality, and provide a better starting point for engagement with companies. Being able to scrutinise a company’s strategy, and the social and environmental risks it contains, would vastly raise the standing of responsible investment among boards and mainstream investors.

The UN Principles for Responsible Investment could spearhead this development, as executive director James Gifford argues in our debate from p30. The message of the PRI – about investing for the long term, engaging with companies and working with policymakers – should resonate now more than ever before. To do this the PRI will have to clear up the distinction between ethical investment – which screens companies against ethical issues – and more moderate responsible investment.

But there is a danger that decades of financial innovation will now be demonised. This would overlook how the dispersal of risk – through techniques such as securitisation and credit derivates – has benefited economies around the world. These methods have freed up lenders to provide more and cheaper credit to companies and individuals in the real economy. The problem is that these techniques came to be seen as ends in themselves – a way for traders to make a fast buck – rather than as the means to the end of sustaining credit lines to businesses that need them to grow and prosper.

The finance industry must now reassert the link between modern finance and the bigger social objective of a sound economy. Just as investors need to reconsider why it is they invest, so banks and other financial institutions need to rethink what their purpose is. Is it to find ever-more innovative ways to make their bonuses bigger? Or is it to support a healthy economy?

We may wait in vain for the masters of the universe to start understanding their role as servants of the people. But as the public backlash, government scrutiny and the threat of regulation rise, everyone in finance has a reason to make the case for sustainable markets. Responsible investors can lead the way.



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