Investing with Impact

Why Finance is a Force for Good

Jeremy Balkin

• Publisher: Routledge
• Year: 2016
• Print ISBN: 9781629560588
• eBook ISBN: 9781351861625
• Topic: Business
• Subtopic: Business General
• Index: Business

Investing with Impact: Why Finance Is a Force for Good outlines the roadmap to reinvigorating a skeptical public and demoralized financial services industry by making the case that, contrary to popular misconception, finance is not the cause of the world's problems; in fact, it can provide the solution. Author Jeremy Balkin presents the case that the finance industry can improve the state of the world by positively influencing the allocation of capital.  Investing With Impact explains the methodology of Balkin's 6 E Paradigm, opening the toolbox to this revolutionary framework for the first time. In so doing, Balkin expands the impact investment universe, enabling mainstream capital to flow where opportunities generate positive investment returns and have demonstrable social impact.  Described by the Huffington Post as the "Anti-Wolf of Wall Street," Balkin is challenging the status quo on Wall Street by leading the intellectual debate embracing the $1 trillion frontier impact investment market opportunity. The book demonstrates conclusively that, if we can change the culture in finance, we can change the world for the better.

Chapter
1 The Blame Game

The global financial crisis of 2008 brought the world to the brink of economic catastrophe. In a March 2009 speech at the Council on Foreign Relations in Washington D.C., United States Federal Reserve Chairman Ben S. Bernanke asserted, "The world is suffering through the worst financial crisis since the 1930s, a crisis that has precipitated a sharp downturn in the global economy." Bernanke was notionally responsible for crafting the United States' monetary policy response to the global financial crisis, and his unique insight is telling. In fact, his acute understanding of the Great Depression, overlaid with the contemporary response to the global financial crisis, renders him perhaps the single greatest authority on the subject. In the same speech, Bernanke stated, "[The crisis'] fundamental causes remain in dispute," but said, "[i]n my view, however, it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s."¹

Perhaps Bernanke is right and the global financial crisis did not happen in isolation, nor as a sudden random event. In this view, the global financial crisis was the culmination of a series of incremental events that, over time, eventually caused the economy to burst at the seams. Countless books and newspaper column inches have attempted to explain the global financial crisis; this book does not seek to add to those economic histories but rather to inspire the future direction of enlightened participants in banking and financial services. Condensing the global financial crisis into a simple television news sound bite or five-hundred-word blog post is rather difficult, and the financial system is so complex that the vast majority of people lack the necessary background to comprehend the gravity of the problem. Therefore, biases and prejudices tend to play a significant role in shaping opinions.

Clearly, there needed to be a scapegoat for the global financial crisis, so people could visualize the enemy and conceptualize an entity that could be blamed. Hence, characterizing Wall Street bankers as "evil"² may have appeased some because that narrative presents a simple view that banking failure alone caused the global financial crisis. However, this tendency to scapegoat created a much broader issue in the years that followed, as the concept of responsibility became a political issue, making assessments and solutions to the problems that caused the crisis more difficult to reach. In other words, if we fail to understand the proper causes of the global financial crisis, how can we correct them? The capitalist system entrusts human beings with the freedom to choose their actions, empowered by the philosophy of enlightened self-interest. In 2008, the system itself did not fail; rather, the crisis represented a collective moral failure of the participants in the system. Assigning blame to individuals or firms is neither accurate nor effective as a means of understanding the failure.

In February 2009, Time magazine produced a list of "25 People to Blame for the Financial Crisis,"³ Interestingly, number three on the list is the immediate predecessor of Ben Bernanke, former United States Federal Reserve Chairman Alan Greenspan, Described as "an economist and a disciple of libertarian icon Ayn Rand," Greenspan "presided over a long economic and financial-market boom" and "attained the status of Washington's resident wizard." Time added, "his long-standing disdain for regulation" would be one of the "leading causes" of the mortgage crisis. This analysis may reflect Greenspan's personal preference for laissez-faire regulation, but ultimately the responsibility of making and enforcing laws resides with the government, not the central bank. Therefore, laying blame for the global financial crisis on any single individual, let alone on an eighty-three-year-old man, seems as ethically flawed as some of the broader moral failures permeating society in the lead-up to the crisis.

Rolling Stone magazine offered an alternative analysis regarding "the history of the recent financial crisis" in a July 2009 article. Whereas Time compiled a list of people responsible, Rolling Stone argued, "The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money."⁴ Perhaps unbeknownst to many, Goldman Sachs was "the world's most powerful investment bank," apparently, given the coincidence that numerous former employees occupied key roles within the United States Treasury and rival firms at the time of the collapse of Lehman Brothers. The article failed to clearly articulate what motivation, if any, former Goldman Sachs employees would have to give preference to their former firm at the time of the global financial crisis. In fact, it is ridiculous to lay blame on firms like Goldman Sachs that remained robust during the crisis rather than attributing any responsibility to the firms like the shadow banking clique, including Lehman Brothers, that monumentally collapsed, resulting in the chaos of the global financial crisis.⁵ Conspiracy theories may be attractive and commercially lucrative on the newsstand, but they fail to address reality.

As elements of the media fuelled the blame game, the witch hunt and outcry for mob justice continued unabated. Unsurprisingly, the global financial crisis brought an increase in age-old conspiracy theories and rhetoric targeting minority groups. In a report published by the Anti-Defamation League in 2008, National Director Abraham H. Foxman explained, "Hate groups and anti-Semites used the global economic downturn to breathe new life into old myths of greedy and money-hungry American Jews, and these took on a life of their own on the Internet and in the real world."⁶ In a study published in June 2009 by the Boston Review, titled State of the Nation: Anti-Semitism and the Economic Crisis, a strikingly high 38.4 percent of people surveyed attributed at least some level of blame for the crisis to Jews.⁷ The historical inaccuracy of attributing blame to members of the Jewish faith, who make up less than 0.2 percent⁸ of the world population and just 2 percent⁹ of the U.S. population, provided an intriguing explanation as to the cause of the global financial crisis. Nonetheless, the results are deeply concerning for a country that prides itself on diversity.

Diversity of opinion and freedom of speech are hallmarks of the vibrant democracy of the United States, and are enshrined in the Constitution. The ultimate arbiter of a robust democracy, however, is the degree to which people can criticize their elected officials. In 2012, the Pew Research Center conducted a study about where middle-class Americans place "blame" for their financial woes and found that 62 percent blamed Congress "a lot."¹⁰ After all, it was Savoyard philosopher Joseph-Marie de Maistre who wrote in 1811, "Every nation gets the government it deserves."¹¹ Unsurprisingly, when the respondents were asked whether they blame themselves, nearly half, 47 percent, replied "not at all."¹²

There is a unique connection behind the respective possible causes, be they plausible or implausible, of the global financial crisis. Put simply, humans are responsible for the failures that led to the economic devastation that began in September 2008 with the collapse of Lehman Brothers. Humans were entrusted with the freedom to exercise choice in their decision making, empowered by the moral philosophy of enlightened self-interest. Therefore, virtually all human beings ought to collectively share at least some element of responsibility for the egregious moral and ethical failures that were propagated at the time of the crisis. After all, as a society we benefited directly or indirectly from the increased employment, rising stock market, booming housing market, higher government tax revenues, and increased economic activity propagated at the time. It is therefore disingenuous to accept the rewards without accepting at least some degree of the responsibility.

There is no doubt that some sections of the population are disproportionately more responsible for sowing the seeds for the global financial crisis than others, including excessively greedy Wall Street bankers and traders. In October 2014, former chairman of the Swiss National Bank, Philipp Hildebrand, told a panel at a meeting of the International Monetary Fund that "this was not just a problem of rogue individuals."¹³ Mr. Hildebrand went a step further and explained that "very significant sectors of society were in on this. We all have to recognize this was not just the failure of individuals, but a collective failure of society at large."¹⁴ Indeed, leading figures in other sections of the community, including politicians, were eager to be associated with the wealth and excesses of prominent financial figures in the lead-up to the 2008 crisis, and were beneficiaries of the boom times. Ultimately, we cannot change the past, but we all share responsibility for the outcomes perpetrated by the moral and ethical failings and have a vested interest in repairing the broken world for future generations. If we fail to address these core issues, there will be change imposed by outside interests in ways that are counterproductive to future growth and prosperity.

You Break It, You Own It

Article I, Section 1, of the United States Constitution reads, "All legislative Powers herein granted shall be vested in a Congress of the United States, which shall consist of a Senate and House of Representatives."¹⁵ Members of Congress are elected by the citizens of the United States and bear responsibility for regulatory oversight failure. In 2011, the 108th mayor of New York City, Mayor Michael R. Bloomberg, said, "It was not the banks that created the mortgage crisis. It was, plain and simple, Congress who forced everybody to go and give mortgages to people who were on the cusp."¹⁶ Mayor Bloomberg's comment is particularly insightful given his immense experience in financial services and politics, and offers a unique perspective on the root causes of the crisis.

Clearly, the U.S. government played a significant role in the lead-up to and aftermath of the global financial crisis. In a democracy, elected officials enact legislation and regulations that establish the rules of the game. Government enacted legislation that actively facilitated the rapid expansion of financial institutions. Specifically, the Gramm-Leach-Bliley Act was passed in 1999 and effectively repealed part of the Glass-Steagall Act of 1933, which had prohibited any one financial institution from acting as any combination of a commercial bank, investment bank, security firm, or insurance brokerage. Repeal of Glass-Steagall and replacement of it with the Financial Services Modernization Act (Gramm-Leach-Bliley) became law under the forty-second president of the United States, Bill Clinton. This single legislative measure, signed into law by the rhythmical stroke of the president's pen, would herald a brave new world of global banking growth, merger and acquisition, and consolidation.

The government benefited greatly from the increased economic activity and tax revenues created by the economic boom. The financial services industry made up 10 percent of total U.S. corporate profits in 1949, peaked at 40 percent in 2003, and was over 30 percent in 2014.¹⁷ Decades of financialization,¹⁸ a term economists use to describe the growing size, deregulation, scale, and profitability of the financial sector relative to the broader economy, allowed banks to grow massively in the years leading up to the global financial crisis. By 2006, the financial services industry contributed 8.3 percent to U.S. gross domestic product, compared with 4.9 percent in 1980 and 2.8 percent in 1950.¹⁹

As economic globalization expanded in the 1990s, financial services industry modernization was required to keep pace with the growth. This required further deregulation, with reductions in bank lending and leverage restrictions effectively removing the impediments to continued global economic growth. In 2004, the U.S. Securities and Exchange Commission amended the net capital rule and permitted broker-dealers with at least $5 billion in "tentative net capital" to apply for an exemption from the established calculation method for computing net capital. The "Bear Stearns exemption"²⁰ effectively replaced the 1977 net capitalization rule that capped a twelve-to-one leverage limit, allowing banks to increase leverage unchecked. Bear Stearns would eventually collapse, in March 2008, with leverage as high as $42 of debt for every $1 in equity.²¹

More debt allowed banks to have more money to play with. Excessive leverage was allowed because the cost of debt was so cheap, fuelled by record-low interest rates. As globalization spread capitalism across the world, banks played a critical role in the facilitation and disbursement of financial capital internationally. In this brave new world of financial innovation and banking economies of scale, the circumstances essentially created a Pareto efficient outcome, in which customers, shareholders, and governments all benefited. "Pareto efficiency" refers to a situation in which resources are distributed in such a manner that one stakeholder cannot benefit without making another stakeholder's situation worse. It is important to remember that massive global banking expansion was not driven solely by the invisible hand of the market, altruism, or even the customer's best interest. In delicate yet simple terms, bigger banks meant bigger profits. Bigger profits meant bigger executive bonuses. Bigger bonuses also created an incentive to take bigger risks. These risks eventually became so big that certain banks were deemed too big to fail.

Biting the Hand That Feeds

In testimony on June 6, 2009, in front of Congress, United States Treasury Secretary Timothy Geithner stated, "I think that although many things caused this crisis, what happened to compensation and the incentives in creative risk taking did contribute in some institutions to the vulnerability that we saw in this financial crisis."²² On balance, Wall Street's compensation structure was skewed toward short-term performance, giving traders huge incentives on the upside and very low risk to themselves on the downside. In a system where some financial institutions are deemed too big to fail, the economic risk is mispriced and effectively transferred from the private sector to the government backstop. Essentially, the financial gains are generated by the private banking sector but losses are incurred by the government, or, specifically, the taxpayer. In other words, Wall Street is bailed out by Main Street.

Critics of "too big to fail" like former head of the United States Federal Reserve Alan Greenspan argue that, "If they're too big to fail, they're too big,"²³ and therefore believe that such large organizations should be deliberately broken up if their risk management is ineffective. These critics argue that the problem of moral hazard arises, whereby there exists an incentive to seek private profit from protective public policies. This comes about when certain firms deliberately take excessively risky but high-return positions based on the preferential pub...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Dedication
• Contents
• Introduction
• Chapter 1 The Blame Game
• Chapter 2 Consequences of the Crisis
• Chapter 3 Reimagining Prosperity
• Chapter 4 Investing with Impact
• Chapter 5 The Case for Impact: 6E Paradigm
• Chapter 6 Finance as a Force for Good
• Conclusion: We, the People
• Acknowledgments
• Notes
• Index
• About the Author