Making Finance More Responsible

If you ask social investors whether responsible finance should be the “new normal” in microfinance, the answer is always yes. For most “social-first” and mission-oriented investors, client benefit has been the driving force from their entry into microfinance. For the more “finance-first” social investors, questions coming from shareholders and the public at large have increased their focus on client protection and social performance.

One proof of this is that over fifty direct and indirect investors have now signed on to the Principles for Investors in Inclusive Finance (PIIF). Both retail providers and investors face pressures that can challenge the “new normal” goal of responsibility. These include disbursement and time pressure, staff compensation incentives, increased competition, limited risk appetite and possibly unrealistic financial return expectations. How can their incentives be aligned with the investor behavior that is aspired to in these principles?

Investors play an important role in incentivizing their investees to become more responsible as well as to change their own behavior. Let me start with the former.

Investors have a key role to play in incentivizing and supporting retail providers to improve their practices, deliver appropriate products, protect the interest of clients, and have an overall positive impact on clients’ lives. The last Social Investor Roundtable highlighted concrete steps several investors are taking to move from principles to practice. Many have begun to incorporate responsible finance considerations throughout their investment process. They are likely to become more selective.

For example, social investors led by Triple Jump are jointly developing a responsible finance score card to screen potential investees. Elements include effective interest rates charged and dividend policies of the MFI. The Belgian MIV Incofin has a number of years of experience with its dashboard of 43 environmental and social performance indicators. Investment proposals that fail to meet the cut-off score are rejected. The IFC’s Performance Based Grants Initiative (PBGI) provides technical assistance to its clients to set clear social objectives and strategies, develop procedures and systems to achieve objectives, and monitor indicators and assess progress to improve organizational performance.

Responsible finance policy changes made by investors go beyond screening and due diligence. Finance in Motion for instance, the investment manager for the largest microfinance investment fund in Eastern Europe, has prioritized investing in transformations as transformed institutions can offer a broader range of financial services.

Several development finance institutions, like KfW and EBRD, are incorporating specific conditions in their agreements with investees to avoid over-indebtedness and ensure client protection. Some investors even reward responsible behavior. Oikocredit for example provides a premium to investees that show good social performance. The “extraordinary social relevance discount” can reduce the negotiated rate by 0.25-1.0%.

The PIIFs challenge investors to go beyond making sure that their investees are doing right by clients. It calls on the investors to reflect on how their own practices can be made more responsible, transparent and fair to their investees and other investors. The principles address acceptable risk-sharing on foreign exchange, refraining from pushing more money on investees than they can absorb and use well, avoiding market level overindebtedness, and balancing expectations for financial and social return.

Opinions about what is “fair,” “acceptable” and “balanced” still vary widely. For instance, growth limits proposed by participants at the social investor roundtable were all over the map, ranging from 25 to 100%. On reasonable profit levels, there was even less agreement. MIX analysis of growth and profit suggests that it is indeed very difficult to establish benchmarks on these issues. To start getting at irresponsible investor practices in some markets and fair treatment of investees, a group of social investors, led by Incofin, are working on “responsible covenants” for loan and shareholder agreements for debt and equity investors.

So efforts are under way across the investment community towards more responsible finance. But there are still challenges ahead. Let me highlight three: improving transparency; monitoring and managing market-level risks; and tracking progress. A new development with regards to transparency is greater clarity on “who gets what” in the value chain of financial service delivery — from clients on upwards to staff, management, direct funders and institutional investors. This could be a useful step towards more clarity on fair and balanced returns.

Second, investors need to take a sector wide approach and think beyond their individual deals to developments and risks at the level of the market as a whole. The long-term vision must be sustainable delivery of services to clients. Especially in markets with a near-term risk of over-indebtedness, investors need to be part of the solution by collaborating on market monitoring and diagnostics and taking action based on the findings, including agreeing to adjust funding plans.

Last but not least, the act of endorsing principles is not so hard but living by the rules is far more challenging. The PRI is developing a reporting and assessment framework to track progress in implementation and learn from experiences. The framework needs to be both credible and useful. It is available for public review now and I encourage investors to look at it and provide feedback.

All these issues require collective action by the investor community. A core group of social investors is already is working to “put their money where their mouth is.” The whole industry will benefit if others follow suit.