Social finance

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Social finance serves as a middle ground between traditional business, whose main driver is to achieve financial value and traditional charity, whose main driver is to achieve social value. The-role-of-Social-Finance-source-author.png
Social finance serves as a middle ground between traditional business, whose main driver is to achieve financial value and traditional charity, whose main driver is to achieve social value.

Social finance is a category of financial services that aims to leverage private capital to address challenges in areas of social and environmental need. [1] Having gained popularity in the aftermath of the 2008 global financial crisis, it is notable for its public benefit focus. [2] [3] [4] Mechanisms of creating shared social value are not new; however, social finance is conceptually unique as an approach to solving social problems while simultaneously creating economic value. [5] [6] Unlike philanthropy, which has a similar mission-motive, social finance secures its own sustainability by being profitable for investors. [7] Capital providers lend to social enterprises, who in turn, by investing borrowed funds in socially beneficial initiatives, deliver investors measurable social returns in addition to traditional financial returns on their investment. [8]

Contents

Consensus has yet to be established on a formal definition of social finance due to a lack of clarity around its scope and intent; [9] however, it is said to include elements of impact investing, socially responsible investing, and social enterprise lending. [10] Investors include charitable foundations, retail investors, and institutional investors. [11] Notable examples of social finance instruments are social impact bonds and social impact funds. [9]

Since the 2008 financial crisis, the social finance industry has been experiencing a period of accelerated growth as shifts in investor sentiment have increased demand for ethically responsible investment alternatives by retail investors. [2] [3] Mainstream sources of capital have entered the market as a result, including Deutsche Bank, which in 2011 became the first commercial bank to raise a social investment fund. [12] [13]

New research in the field calls for increasing the role of government in social finance to help overcome the challenges the industry currently faces, including the struggle to produce desirable returns for investors, high start-up and regulatory costs, neglect from mainstream banks, and a lack of access to retail investors. [11] [14] Proponents of social finance argue that until these gaps are addressed, mass participation in social finance will be prevented. [12]

Origin

The history of social finance has its origins in 20th-century neoliberal economics and the ideas that it proposed, such as an emphasis on the role of the free market in society. [15] The concept itself first came in to use in the 1970s in the United States, where it emerged as an innovative approach to solve social problems while creating economic value. The appeal to government was clear: access to swaths of private capital to fund social programs at a time of deep austerity and retrenchment of state programs under neoliberal politics. [11] In 1977 in the United States, the Community Reinvestment Act provided the impetus for financial institutions to invest in underserved local regions and marginalized sectors of the economy, furthering state transfers of wealth to the private sector. This spawned a plethora of community development financial institutions, which deployed significant amounts of capital in affordable housing, renewable energy, and financial inclusion across the United States. Furthermore, many prominent foundations, including the Ford, Rockefeller, and MacArthur Foundations, have actively invested their endowments in a manner that aligns with this practice of mission-related investing. [9] [12]

Some scholars contest that social finance has its origins in Islamic finance, which was practiced by the sharia-compliant Islamic economies of the 1960s and which is characterized by socially responsible investment. [16] [17] [18] [19]

Market structure

Capital flows in the social finance marketplace. Social finance market structure.png
Capital flows in the social finance marketplace.

The social finance ecosystem is composed of four key groups: [11]

  1. Investors: Investors, or capital providers, serve as the initial and primary source of capital in social finance. Examples include retail investors, high-net-worth individuals, pension funds, charitable foundations, and private foundations. [1]
  2. Social enterprises: Social enterprises represent the demand for investment in social finance. They absorb the capital invested by investors, reinvest this money in various socially beneficial initiatives, or social investments, and finally deliver investors twin social and financial returns on their investment. [8] Examples include nonprofit organizations such as the Bill and Melinda Gates Foundation.
  3. Social finance institutions: Social finance institutions act as financial intermediaries by linking the supply and demand of capital. They are responsible for raising funds from investors, pooling these funds, and redistributing them to social enterprises. [11] Social enterprises are ranked by profitability, and preference is given to organizations with strong track records of effective social service. [20]
  4. Intermediaries : Intermediaries facilitate and oversee the myriad connections between the first three groups. They include regulators, trade groups, and service providers. [9] [11]

Scale of operations

Research reveals that the term social finance is familiar mainly to people working in the niche sector of financial services. [21] Since the global financial crisis of 2008, however, the social finance industry has experienced a period of accelerated growth and institutional uptake. For example, in 2011 Deutsche Bank became the first commercial bank to raise a social investment fund, in 2012 Goldman Sachs floated Social Impact Bonds in the US, and in 2012 the European Investment Fund made a direct investment into the UK social finance marketplace. [9]

Explanation of the post-crisis popularization of social finance is the subject of extensive academic research. Social theorist Bill Maurer explains it as the result of shifts in investor sentiment in the aftermath of the financial crisis. Social finance, through its innovative approach to solving social problems while creating economic value, has met the need of disaffected retail investors who seek ethical investment alternatives following revelations in the aftermath of the financial crisis of widespread unethical business practices by mainstream corporations in pursuit of profit. As a result, Maurer suggests, mainstream corporations looking to rebuild their reputations are now entering the market, bringing with them significant inflows of capital and investment. [21]

One study, which provides a statistical analysis of participation, satisfaction, and retention rates in the European social finance market, suggests that the global financial crisis occurred at a time when social finance organizations were beginning to develop track records that demonstrated their market feasibility. [20] Geobey and Harji, in their anecdotal study of social finance in the post-crisis United States, document similar findings in the North American case. Their study, which synthesizes interviews with executives from North American social finance organizations, confirms that demonstration of commercial viability by current actors in the North American social finance market since 2008 has proved themselves to mainstream financiers, enabled the scaling up of operations, and created a "signalling effect" that has attracted new investment and ultimately staved off existential questions that have been asked of the social finance industry. [12]

Proponents of social finance Kent Baker and John Nofsinger claim that these trends of institutionalisation will lead to the legitimisation of the social finance industry, give way to the widespread institutional uptake of social finance, and ultimately embed social finance as a mainstream asset class of financial investments among the likes of stocks and bonds. [8] Several unfavourable trends have also become apparent, however, including uneven uptake, and key challenges remain, including the struggle to produce desirable returns for investors, high start-up and regulatory costs, and lack of access to retail investors. [9] [22] Baker and Nofsinger argue that until these gaps are addressed, mass participation in social finance will be prevented. [8]

Examples

Social impact bonds

A caregiver teaches mothers with small children about nutrition at a hospital in Jinja, Uganda as part of a program funded by the Social Innovation Fund. Uganda Nutrition (40911014075).jpg
A caregiver teaches mothers with small children about nutrition at a hospital in Jinja, Uganda as part of a program funded by the Social Innovation Fund.

Of all forms of social finance, the most used and developed is the Social impact bond (SIB). [7] SIBs are structured financial instruments that raise private capital to fund prevention and early intervention programs in areas of pressing social need, reducing the need for expensive safety net services in the future. Investors provide up-front capital to fund these programs and receive a prearranged amount of money (including the principal plus some financial return) if performance results are achieved. [14]

Funds from SIBs are spent on services like counselling, health care, and detention, with the aim of reducing the need for these services in the first place. Proceeds from the savings are used to reward investors for facilitating the process. [11] Unlike conventional bonds, however, SIBs operate on a pay-for-performance basis, in which bondholders are repaid only if the program’s outcome targets are achieved.

Social investment funds

Social investment funds (SIFs) pool funds from investors to provide not-for-profit organisations with “patient working capital” (funding with a longer-term repayment schedule). [7] The Social Innovation Fund is a well-known example of a SIF. Through a competitive process, it awards grants of up to $10 million per year to organisations with strong track records of effective social service. [14]

Comparisons with other forms of social welfare enhancement

Efforts to create mechanisms to allocate capital for combined social and economic value creation are not new. [5] [23] Social finance is conceptually a very different approach to social welfare enhancement, however, in that, by combining the ideas of neoliberal markets (in creating a profit and financial return) with taking care of social needs (in the way that a charity would), social finance secures its own sustainability by being profitable for those who fund these organisations. [7] It is funded by investors, who receive a return on their investment, rather than donors, who forgo their contribution at the time of donation. [9] The ‘blended’ social and financial returns are a defining characteristic of social finance and distinguish it from related practices, such as not-for-profit investing, charity, and philanthropy. [9]

Comparison with corporate social responsibility

Leading scholars in the field of social innovation, such as Stephen Sinclair, Neil McHugh, and Michael Roy, question the need for social finance given the extensive existing frameworks that govern corporate social responsibility in capital markets. [24] Their critical analysis of the efficacy of social impact bonds concludes that social finance draws capital away from productive investment opportunities and exacerbates allocative inefficiencies caused by excessive existing government regulation. [24] Separate studies reaffirm these claims and argue that improved efficiencies are needed before social finance is marketized. [25]

Proponents of social finance concede that while its intent overlaps with that of corporate social responsibility, social finance provides a means for greater direct investment in addressing social challenges, whereas existing corporate governance frameworks work at the fringe. [4] Othmar Lehner, Associate Professor of Social Enterprise at the University of Oxford Saïd Business School, states that while traditional financial institutions typically prioritise profitability and regard their societal impact only so much as regulation requires, social finance enterprises set social objectives as the first goal of their capital allocation strategies, channelling investors’ funds directly to organisations that prioritise projects with socially positive outcomes. [11] In his opening chapter in the Routledge Handbook of Social and Sustainable Finance, he proposes social finance as a new source of capital to supplement existing sources, such as charitable donations and philanthropic grants, which have historically been the main source of financing social change, from poverty alleviation to international development and income inequality. [11] Social theorists Jed Emerson and Alex Nicholls reaffirm these claims by suggesting that social finance provides the greater direct investment required to address various social challenges and fill the capital gap that currently exists, given that many social needs have increased in severity, complexity, and scale, while charitable donations are on the decline. [9]

Challenges and future direction

The social finance industry faces several headwinds, including the struggle to produce desirable returns for investors, high start-up and regulatory costs, neglect from mainstream banks, and lack of access to retail investors, an area that is believed to have perhaps the most demand. [24] Furthermore, although the industry has matured, it has done so at an uneven pace across its ecosystem, as evidenced in the United States in particular. [25] While capital flows and trust between suppliers (investors) and demanders (social finance institutions) of capital are improving, regulatory developments have lagged behind. [25] One study [12] concedes that the rapid growth of social finance in the 21st century has exposed its self-regulatory capacity, the need to strengthen governance mechanisms, and the need to develop sophisticated intermediaries to link capital and opportunities. The source suggests that institutional uptake of social finance will be held back by these headwinds and, unless the gaps are addressed, the social finance industry will be unable to maintain its current growth rate into the future.

Consensus of experts in the field maintains that the role of government in social finance will be central to addressing the challenges that the sector currently faces. [11] [9] Sustainability strategist Coro Strandberg proposes [26] the following six public policy changes to address these challenges:

See also

Related Research Articles

Finance is the study and discipline of money, currency and capital assets. It is related to and distinct from Economics which is the study of production, distribution, and consumption of goods and services. Based on the scope of financial activities in financial systems, the discipline can be divided into personal, corporate, and public finance.

<span class="mw-page-title-main">International Finance Corporation</span> World Bank Group member financial institution

The International Finance Corporation (IFC) is an international financial institution that offers investment, advisory, and asset-management services to encourage private-sector development in less developed countries. The IFC is a member of the World Bank Group and is headquartered in Washington, D.C. in the United States.

<span class="mw-page-title-main">Capital market</span> Finance

A capital market is a financial market in which long-term debt or equity-backed securities are bought and sold, in contrast to a money market where short-term debt is bought and sold. Capital markets channel the wealth of savers to those who can put it to long-term productive use, such as companies or governments making long-term investments. Financial regulators like Securities and Exchange Board of India (SEBI), Bank of England (BoE) and the U.S. Securities and Exchange Commission (SEC) oversee capital markets to protect investors against fraud, among other duties.

<span class="mw-page-title-main">European Investment Bank</span> Investment bank of the European Union

The European Investment Bank (EIB) is the European Union's investment bank and is owned by the 27 member states. It is the largest multilateral financial institution in the world. The EIB finances and invests both through equity and debt solutions companies and projects that achieve the policy aims of the European Union through loans, equity and guarantees.

<span class="mw-page-title-main">Overseas Private Investment Corporation</span> Government agency of the United States of America

The Overseas Private Investment Corporation (OPIC) was the United States Government's Development finance institution until it merged with the Development Credit Authority (DCA) of the United States Agency for International Development (USAID) to form the U.S. International Development Finance Corporation (DFC). OPIC mobilized private capital to help solve critical development challenges and in doing so, advanced the foreign policy of the United States and national security objectives.

The money market is a component of the economy that provides short-term funds. The money market deals in short-term loans, generally for a period of a year or less.

An investor is a person who allocates financial capital with the expectation of a future return (profit) or to gain an advantage (interest). Through this allocated capital the investor usually purchases some species of property. Types of investments include equity, debt, securities, real estate, infrastructure, currency, commodity, token, derivatives such as put and call options, futures, forwards, etc. This definition makes no distinction between the investors in the primary and secondary markets. That is, someone who provides a business with capital and someone who buys a stock are both investors. An investor who owns stock is a shareholder.

<span class="mw-page-title-main">Financial services</span> Economic service provided by the finance industry

Financial services are economic services tied to finance provided by financial institutions. Financial services encompass a broad range of service sector activities, especially as concerns financial management and consumer finance.

A green economy is an economy that aims at reducing environmental risks and ecological scarcities, and that aims for sustainable development without degrading the environment. It is closely related with ecological economics, but has a more politically applied focus. The 2011 UNEP Green Economy Report argues "that to be green, an economy must not only be efficient, but also fair. Fairness implies recognizing global and country level equity dimensions, particularly in assuring a Just Transition to an economy that is low-carbon, resource efficient, and socially inclusive."

A money market fund is an open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are managed with the goal of maintaining a highly stable asset value through liquid investments, while paying income to investors in the form of dividends. Although they are not insured against loss, actual losses have been quite rare in practice.

Financial risk management is the practice of protecting economic value in a firm by managing exposure to financial risk - principally operational risk, credit risk and market risk, with more specific variants as listed aside. As for risk management more generally, financial risk management requires identifying the sources of risk, measuring these, and crafting plans to mitigate them. See Finance § Risk management for an overview.

The bond market is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market. This is usually in the form of bonds, but it may include notes, bills, and so on for public and private expenditures. The bond market has largely been dominated by the United States, which accounts for about 39% of the market. As of 2021, the size of the bond market is estimated to be at $119 trillion worldwide and $46 trillion for the US market, according to the Securities Industry and Financial Markets Association (SIFMA).

A community development financial institution (US) or community development finance institution (UK) - abbreviated in both cases to CDFI - is a financial institution that provides credit and financial services to underserved markets and populations, primarily in the USA but also in the UK. A CDFI may be a community development bank, a community development credit union (CDCU), a community development loan fund (CDLF), a community development venture capital fund (CDVC), a microenterprise development loan fund, or a community development corporation.

<span class="mw-page-title-main">Caisse de dépôt et placement du Québec</span> Canadian institutional investment company

The Caisse de dépôt et placement du Québec is an institutional investor that manages several public and parapublic pension plans and insurance programs in Quebec. It was established in 1965 by an act of the National Assembly, under the government of Jean Lesage, as part of the Quiet Revolution, a period of social and political change in Quebec. It is the second-largest pension fund in Canada, after the Canada Pension Plan Investment Board. It was created to manage the funds of the newly created Quebec Pension Plan, a public pension plan that aimed to provide financial security for Quebecers in retirement. The CDPQ’s mandate was to invest the funds prudently and profitably, while also contributing to Quebec’s economic development. As of December 31, 2023, CDPQ managed assets of C$434 billion, invested in Canada and elsewhere. CDPQ is headquartered in Quebec City at the Price building and has its main business office in Montreal at Édifice Jacques-Parizeau.

<span class="mw-page-title-main">Socially responsible investing</span> Any investment strategy combining both financial performance and social/ethical impact.

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Conservation finance is the practice of raising and managing capital to support land, water, and resource conservation. Conservation financing options vary by source from public, private, and nonprofit funders; by type from loans, to grants, to tax incentives, to market mechanisms; and by scale ranging from federal to state, national to local.

Impact investing refers to investments "made into companies, organizations, and funds with the intention to generate a measurable, beneficial social or environmental impact alongside a financial return". At its core, impact investing is about an alignment of an investor's beliefs and values with the allocation of capital to address social and/or environmental issues.

Big Society Capital Limited (BSC) is a social impact investor in the United Kingdom. Its mission is to grow the amount of money invested in tackling social issues and inequalities in the UK. It invests its own capital as well as enabling others to invest for impact too. The capital finances front-line social purpose organizations tackling everything from homelessness to mental health and fuel poverty, enabling them to grow and increase their impact.

<span class="mw-page-title-main">Capital Markets Union</span> European economic policy initiative

The Capital Markets Union (CMU) is an economic policy initiative launched by the former president of the European Commission, Jean-Claude Juncker in the initial exposition of his policy agenda on 15 July 2014. The main target was to create a single market for capital in the whole territory of the EU by the end of 2019. The reasoning behind the idea was to address the issue that corporate finance relies on debt (i.e. bank loans) and the fact that capital markets in Europe were not sufficiently integrated so as to protect the EU and especially the Eurozone from future crisis. The Five Presidents Report of June 2015 proposed the CMU in order to complement the Banking union of the European Union and eventually finish the Economic and Monetary Union (EMU) project. The CMU is supposed to attract 2000 billion dollars more on the European capital markets, on the long-term.

Sovereign funds of China are mechanisms through which the Chinese state acts as a market participant with the goals of supporting key domestic economic sectors, advancing strategic interests internationally, and diversifying its foreign exchange reserves.

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Further reading