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For many years, Adam Smith’s metaphor of the “Invisible Hand,” as expressed in “The Wealth Of Nations,” was the best illustration of the thinking behind free market ideology. This ideology holds that in a market free from government interference, unseen forces like the interplay between supply and demand will result in a natural flow of trade and fluctuation of prices that will fulfil society’s collective interests. This vision is based on the concept of individuals as purely rational beings, well-informed of their options and capable of making sound financial choices based on those options. Over time, this ideology led to the promulgation of policies and laws aimed at relaxing financial regulations — yet the consequences of these decisions have become impossible to ignore.

The almost metronomic succession of financial crises we have experienced since the mid-80s is a clear indication that financial deregulation — combined with deregulation and privatisation in other key industries — has brought with it an extraordinary amount of market instability. The first of these financial crises broke out in the U.S. in 1987, with the Wall Street crash happening shortly after the country had passed financial deregulation laws in 1985/86. Barely two years later came the Saving and Loans crisis. Then in 1991-1992, a real estate crisis hit Europe, with 1992 also marking the first European Monetary System crisis, followed by a second one a year later. In 1994, the Mexican Tesobonos crisis happened, then financial crises spread across Asia in 1997 and again a year later. In 2001, the internet stock market crisis broke, and later that decade the subprime mortgage crisis sparked the 2008 global financial crisis — the largest since the Great Depression.

Some reforms and agreements have tried to address this instability, or at least temper it. The U.S. and U.K., along with other countries, introduced new regulatory policies in the aftermath of the 2008 crisis. And internationally, the Basel Accords were updated in the wake of that crisis, building upon the ongoing efforts of several key global economies to strengthen banking supervision and thereby promote stability in the financial world. However, since this update represented the third such Basel agreement since the late 80s, it’s clear that these efforts to strengthen the banking sector have been too timid. And attempts at more ambitious reforms — such as the recommendations made by the Vickers Commission in the United Kingdom, which aimed to institute the separation of commercial and investment banking — have been abandoned due to push-back from the private sector.

Nevertheless, these efforts to re-establish a greater degree of government supervision in the financial sector show that the logic of “laissez faire” economics and the belief in the core rationality of market decisions has gradually fallen by the wayside. And as the global economy (and the financial crises that have plagued it) have become more complex and interconnected, it’s becoming clear that traditional free market approaches to finance are incapable of meeting the world’s current and future needs. To take one key example, the growing need for climate action has revealed the limitations of these approaches, as most investments are still tied to polluting assets, despite the urgent need for finance to accelerate the transition to a low-carbon economy.

Meanwhile, a growing global emphasis on leveraging finance to advance development — as embodied by the Sustainable Development Goals (SDGs) — has led to the emergence of “impact finance.” An attempt to reform finance from within, impact finance aims to transform the practices and ethics of traditional finance by putting profitability and positive impact on the environment and society on equal footing.

At Convergences, we refer to these efforts as “changing the profitability paradigm” — i.e., shifting from the traditional way of seeing investments as an end in themselves, to viewing them as a powerful tool for ecological and social transitions. This paradigm shift is what the Impact Finance Barometer is all about. Three years ago, we launched our first Impact Finance Barometer, a publication that explores key figures and global trends in financial inclusion and impact investment. Through articles, personal accounts, and reflections from multiple stakeholders in finance (investors, beneficiaries and advisors), the Barometer invites readers to question financial practices and gain a better understanding of the ways finance can be leveraged for the common good. Below, I’ll share some of the trends and insights highlighted in the 2023 Impact Finance Barometer.

The relationship between risk and return in the financial sector

According to the Institut de la Finance Durable — a Barometer contributor that works to coordinate actions in sustainable finance to achieve the energy transition and the broader transition to a more inclusive economy — impact finance is “an investment or financing strategy that aims to accelerate the fair and sustainable transformation of the real economy, by providing proof of its beneficial effects.” Based on three pillars (intentionality, additionality and impact measurement), it prioritises the joint pursuit of ecological and social performance and financial profitability, the adoption of a clear and transparent methodology, and the accomplishment of environmental and social objectives that must be achieved within international reference frameworks such as the SDGs or Environmental, Social and Governance (ESG) investing criteria.

Impact finance therefore makes it possible to rethink the risk-return trade-off in the financial sector, by adding the variable of impact. In traditional finance, investment return and risk are closely linked, with a risk-free investment yielding little return, and riskier investments typically offering greater returns (assuming they’re successful). But in impact finance, a positive impact is linked to a reduction in risk. In fact, this new variable of impact is fully integrated into the variable of risk: Investors in green or social projects want to limit their risk, because while less risk means less profitability, it also means fewer negative effects on the communities or environments impacted by the investment, and therefore more financial costs avoided in the long term.

At the Convergences 3ZERO World Forum, where the 2023 Impact Finance Barometer was launched, Jérôme Courcier, Senior Advisor at KPMG discussed a recent study by KPMG on the mergers and acquisitions sector, showing that 50% of the investors questioned admitted having stopped a deal that they considered too risky. This demonstrates the growing importance of taking risk into account when evaluating an investment: Whether it’s due to the influence of impact finance or simply to broader concerns about instability in the global economy, this heightened focus on reducing investment risks is a key development in the ongoing evolution of the financial sector.

Transparency, ethics and regulation of the financial system

In an ethical and legal context, transparency in the financial sector refers to the need for companies to disclose relevant financial information in an accurate, complete and timely manner.

For example, FADEV, an investment company based in Montreuil, France (and another contributor to the Barometer), stresses that the transparency and traceability of its activities are paramount. FADEV supports the economic development of African countries by investing in ethical small and medium enterprises (SMEs), using capital provided by individuals who want to put their savings to good use. As such, the people investing in FADEV know in which geographical area their money is being invested, what financial mechanisms are being implemented in these investments, which companies they are investing in, how their portfolio companies are performing, and how their investments support the growth of SMEs.

Yet transparency is not a cure-all. History has shown that government incentives for major investors are not enough: Even with information and the freedom to choose the least risky investments, big investors (and even many smaller ones) often still opt for short-term profitability, with little regard for the risks involved. Yet it is this deadly logic that has led to the ecological and social disasters the world is now facing.

Several attempts at loose, often voluntary regulation have been made in recent years to shift investors’ focus to the longer term. For example, the European Union introduced the “Green Asset Ratio” to encourage banks to hold more green assets — i.e., assets invested in sustainable or environmentally responsible economic activities — on their balance sheets. Yet it is estimated that among the EU’s major banks, only 3% of their balance sheets is made up of green assets. This suggests that, in the absence of tighter regulations, banks are voluntarily deciding to own very few of them. The Green Asset Ratio should therefore move from the status of indicative information to that of a commitment, by establishing a green asset “floor” — i.e., a minimum level of green assets that must be held by the banks.

Channelling financial flows to key players

While improving transparency and reducing risk to avoid recurring crises and stabilise the economy is a key goal of impact finance, the underlying objective is to put finance back at the service of the common good.

But how can investors best support this goal? Several organisations have addressed this tricky question: To take just one example, the Impact Investing Institute, a research/advocacy organisation which also contributed to the Barometer, is proposing the Just Transition Criteria, a tool to help investors align their investments with the objectives of the transition to carbon neutrality. As discussed in the Barometer, “In practice, the Just Transition Criteria help investors to align their financial product with the three key components of a just transition: advancing climate and environmental action, improving socio-economic distribution and equity, and increasing community voice.” This type of criteria should involve democratic considerations, as organisations that promote these measures should seek to reflect the priorities of their internal stakeholders, while also including external stakeholders in the global transition process.

The challenges of increasing investment in carbon neutrality-focused businesses and initiatives arise from the fact that the local level, which is often ignored by investors, is the stage at which both ecological and social/economic transitions can take place most rapidly. To address this issue, our two Barometer contributors KSAPA (a consultancy offering ESG/Corporate Social Responsibility solutions in the areas of advice, investment and advocacy for companies and investors), and Société Générale (one of the main systemic French banks), are working to set up financial inclusion mechanisms for small farmers, so that they can be better integrated into the major agricultural transitions that are currently taking place in Africa. They point out that 2 billion people in the world depend on agriculture for their livelihoods, making it important to provide them with better access to financial services. What’s more, this population represents an opportunity for the entire value chain, including customers and service providers: both a market opportunity, through increasing financial institutions’ customer base, and an opportunity for impact, by improving these small farmers’ financial inclusion. The partnership between KSAPA and Société Générale initially targets Côte d’Ivoire, and will include not only consumer finance products but also investment credit schemes. If these schemes prove effective, the two companies will replicate them in other agricultural value chains in Africa.

Changing the profitability paradigm

It is essential to challenge the current paradigm in the financial sector, with its exclusive focus on financial profitability. We need to recognise that the single-minded pursuit of monetary profit does not consider long-term environmental and social impacts. To effectively mobilise the financial resources needed for ecological and social transitions, it is imperative to integrate other variables beyond immediate financial profitability. This means considering environmental factors such as the sustainability of business practices and clean energy investments, as well as social factors such as equity, social justice and inclusion. By adopting a more holistic and sustainable approach to investment, the financial sector can play a crucial role in promoting more balanced and resilient development, while generating long-term financial returns.

The initiatives, partnerships and regulatory approaches discussed above represent just a few of the countless actions that are emerging across the planet, aimed at changing the profitability paradigm on a global scale. But for this momentum to continue to grow, these actions must resonate across all sectors and geographies. That’s why Convergences is working through several initiatives — both editorial, like the Impact Finance Barometer, and programmatic, like the 3ZERO World Forum — to strengthen coordination, knowledge sharing and multi-stakeholder dialogue at all levels.

These initiatives are part of Convergences’ 3ZERO strategy, which aims to advance the 17 SDGs under three strategic pillars so that all the key players involved can more easily coordinate their work. These pillars focus on the goals of Zero Exclusion, Zero Carbon and Zero Poverty.

We urge all players in the many sectors involved in global development to take the measure of the task before us: financing the “3Zero” transition and enabling the completion of the SDGs. It is currently estimated that over $6 trillion is needed to finance sustainable infrastructure around the world, particularly in emerging and developing countries. As of today, the world is not on track to meet this funding target. It is urgent that we all mobilise to tackle this problem head-on.

We believe this global mobilisation is the only way to achieve a 3Zero world. We are betting on the multiplication and alignment of the initiatives mentioned in this article and the broader Barometer to bring about change. Through efforts like the Impact Finance Barometer, we’re bringing together a group of like-minded organisations willing to work alongside us to spark this change — before it’s too late.

Lucas Magnani is a Publications Officer at Convergences.

Photo courtesy of fauxels.