Let us take the next 15 minutes and reimagine the financial industry.
An investment banker walks to work at 6:00 am (yes, even in this example bankers wake up early). They open their email, respond to clients, and look at their assigned portfolios. Some investments focus on purely the private sector, while others work with the public sector to tackle Official Development Assistance (ODA) projects. All investments within the banker’s portfolios measure and take into account economic, social, and environmental costs.
This is not a fictitious example. In fact, we have coined a new movement to describe it: The Innovative Finance Revolution. Put simply, innovative finance mechanisms are, “non-traditional applications of ODA, joint public-private mechanisms, and flows that either support fundraising by tapping new resources or deliver financial solutions to development problems on the ground” (Taskforce Working Group 2, 2009). Financiers are merging private capital markets with public systems in ways that promote the common good and make money for investors by doing so. Innovative finance uses traditional financial tools like pooled insurance and securitized debts to (1) unlock new resources to solve development problems, (2) find cost-effective interventions, (3) generate profits, and (4) allow investors to diversify their holdings with financial products.
It is important to note that innovative finance does and should not replace traditional resource flows such as aid, FDI, and remittances. Instead, it complements them. Similarly, the innovative finance revolution is no call to action for the financial industry to forgo all pure-profit investments. It is simply bringing in a new way of using the free market to solve problems.
Three recent examples of its application can help unpack this albeit complex concept:
- UK-Goldman Sachs Partnership for MDG. In 2002, the United Kingdom Treasury realized it was not providing enough money to accomplish the Millennium Development Goals, a set of global efforts to tackle poverty. Seeking a solution through capital markets, the government approached Goldman Sachs, which used traditional structured finance to transform pledges for future aid spending into funding for MDG projects. Because the UK government planned on spending a significant amount for MDG over a 15-year period, the firm used this underlying asset of sorts to create a new bond provided through future government development aid. The British government and Goldman then decided that the best way to spend the money they would raise by selling such bonds was investing in immunization campaigns. The resulting “vaccine bonds” received an AAA rating and have raised more than $5.25B for MDG.
- African Risk Capacity Insurance Modeling. Northern Africa has battled severe and frequent droughts. After years of relying on emergency relief and aid, three countries decided to do something different. Marutiana, Niger, and Senegal bought so-called pooled risk insurance products from the African Risk Capacity (ARC), an agency started by the African Union and Rockefeller Foundation. These insurance products covered $60 million in annual droughts for a premium of between $1.9M and $9M. In addition to the insurance offer, the ARC required each country to develop an emergency preparedness plan demonstrating the ability to use any payment received from the ARC effectively. In 2015, after a drought struck the three countries, each received ~26M to remedy the costs of the natural disaster. This was enough to help the countries’ people get back on their feet in a timely manner and without dependence on UN aid.
- Pay for Success. I covered this form of innovative finance earlier this year. However, I want to mention it as a third example of a successful version of innovation within the finance industry. Pay for Success hinges on a public-private partnership jointly accomplishing a social or environmental project. A private firm pitches a project idea and works with the government to define the program’s measurements of success. Once both parties sign on, the private firm finances and develops the project. If it succeeds, it receives its principal and a return of 5-13%. If the project does not meet the agreed-upon measurements of success, the private firm loses its principal. Such social impact bonds incentivize the development of programs with a higher social and environmental return.
Seeing as how there is huge potential within innovative finance, how do we achieve larger scale? First, innovative financial products need to continue to provide its investors attractive yields while minimizing risks. Products need to be fine-tuned and tested repeatedly to give investors an incentive to enter this still unfamiliar area. Second, we need to establish rules and norms for measuring social and environmental impact. This way, innovative finance can operate within defined structures. Third, and most importantly, we cannot be afraid of public-private partnerships. In the past, I have worked with many non-profits which fear intervention by the private industry. Seemingly divergent goals and profit-seeking motives scare off the government and non-profits; however, the private industry offers time-tested financial tools and expertise which are necessary to solving public good concerns.
Through well-defined and contained partnerships, innovative finance can be a vehicle for change both within the private industry and public sector. If we undergo more testing, accumulate more data, and above all keep an open mind, change can happen. If industries work together and offer their best attributes, we can use business for good.