“We need to build a bridge between the world of development finance and private investors”

My interview with Cardano Development, Amsterdam – March 7th

The recently agreed UN Sustainable Development Goals (SDGs) require in the order of USD 2-3 trillion per year additional funding for emerging markets and developing economies (EMDEs). The biggest sums are required for infrastructure, climate change, and agriculture. Herman Bril, Managing Director at Cardano Risk Management Limited in London, researches the role of Multilateral Development Banks “MDBs” and Development Finance Institutions “DFIs” as financial intermediaries operating in financial markets. His aim is to understand how these institutions can better leverage their role and mobilize private investors. The research is part of the dissertation of his Masters of Studies in Sustainability Leadership at the University of Cambridge and serves as a feasibility study for Cardano Development.  We’ve asked Herman to tell us more about his motivations for the study, and to give us an insight into the initial findings of his research.    

Herman: “In recent years it has become obvious that we all need to work together on creating opportunities and solutions for billions of people living in EMDEs to improve their lives in the broadest sense. The SDGs are very ambitious targets to achieve these much needed improvements. But this requires big investments from both public and private, national and international sources for the next decennia. So this is not about solving a ‘one million dollar’ question but a multiple trillions of dollars challenge. These amounts of money may be overwhelming, but when you note that global savings are at around USD 22 trillion per year, there should be ways to bridge the finance gap.”

On bridging the sustainable development finance gap

Herman has worked as Managing Director of Cardano Risk Management for 7 years now. The company helps pension funds, insurance companies and other organisations to become more resilient, and apply this approach across a range of fiduciary management, risk management and investment advisory services.  There is a growing pressure on institutional investors, such as pension funds, to include SRI and ESG in their investment portfolio. We seek Herman’s opinion on what constitutes the right balance between public and private finance to fund the SDGs in Emerging Markets and Developing Economies? 

“Developing and promoting private entrepreneurship and implementing market based solutions or financial risk mitigating solutions, is the only sustainable way for economic growth and development.”

Herman: “We literally need to build a bridge between the world of Development Finance and private investors, such as institutional investors, in OECD countries trying to improve to match global demand and supply in finance. These two different finance worlds hardly know each other and are not connected sufficiently. The right balance does not exists and is very different per country depending on GDP per capita, institutions, macro-economic and monetary policy and a whole range of factors. The poorest countries are really dependent on Official Development Aid (ODA). Ultimately every country need the bulk of the finance coming from local private and public sources – like the tax base – but supplemented with private international funds like Foreign Direct Investments (FDI). To get there, MDBs and DFIs can play a catalyst role to provide what they call Other Financial Flows (OFF) and mobilize private investors.”

On the realism to assume that these large sums of money will be invested

Financing of the UN SDGs requires 2-3 trillion dollars every year, with additional financing for infrastructure estimated between 5 and 7 trillion dollars annually. Your research covers the role of MDBs and DFIs in the mobilization of private finance, is the current volatility in international markets a threat to the feasibility of this? How realistic do you think it is that these trillions will be sourced and sufficiently allocated?

Herman: “In reality this will be extremely challenging for many reasons. Market stress and volatility always leads to risk aversion, especially by private investors. Moreover, many projects are not bankable, the safeguard requirements are not always achievable, too much country risk or perceived risk, corruption, lag of legal and institutional framework; and many other obstacles. There is a central role for MDBs and DFIs to create the demand by providing TA and other forms of expertise to make projects bankable. It is extremely important that MDBs and DFIs provide additionality through the cycle of booms and busts and sometimes have to act as lenders of last resort in some countries.”

How to crowd in new investors and private capital

Based on your experience with advising institutional investors in The Netherlands and the UK, can you elaborate more on potential financing mechanisms to tap capital markets, institutional investors? What is needed to crowd in their commitment and capital? Especially for infrastructure finance?

Herman: “MDBs and DFIs can be more active as ‘originate and distribute’ financial intermediaries instead of ‘asset gatherers’.  They could become more active in syndicated loans, co-financing, parallel loans or securitizations and recycle their assets to the institutional investors. These techniques can potentially be blended with guarantees if institutional investors have issues with the perceived risk/return.  Another technique is tranching for different type of risk / return rated notes in case of securitization.”

Herman: “Regarding infrastructure, the biggest challenge is the initial development phase. This is the most risky part for investors. Once the project is ready and operational it starts to produce a more steady cash flow stream which institutional investors are willing to pre-finance. So MDBs and DFIs can provide additionality in the initial phase dealing with stakeholders, safeguard requirements, and documentation before institutional investors step in the second phase of the project. Moody’s did a very interesting long term study on the risk of infrastructure and it clearly showed the sharp risk reduction after the first years of the project.”

On the role of innovative financing mechanisms

In 2010 Cardano Development was initiated to broaden the philosophy of providing stability and resilience through financial risk management techniques to frontier markets where access to these services is limited. Under the leading role of Cardano Development new initiatives like BIX Capital, Coin Re and Impact Loan Exchange are created, and funds such as FrontClear and TCX have been established. At the beginning of 2016, Cardano Development and its initiatives have become a company with over USD 800 million assets under management, 30 employees. As the former Director of Cardano Development, you have experience in developing innovative financial risk management solutions and setting up funds to mitigate financial risks in frontier markets. We wonder how significant the role of financial innovation will be.

Herman: “Financial innovation is crucial in my mind. And the reason is that this massive funding gap requires scale to make a meaningful impact. Scale can only be realized if institutional investors are stepping up. But they will only invest at scale if they can invest in rated, liquid and market risk/return bonds. A good example is the mortgage bond markets in OECD countries were banks originate the loans but fund this in the capital markets. But we have to do this in a responsible and sustainable way and clearly avoid what happened in the US subprime mortgage market.” 

When it comes to innovative projects, failure rates are high. We ask Herman if he can elaborate on the key success factors and challenges for a pioneering organization like Cardano Development, that plays an incubator role for new initiatives.    

Herman: “Cardano Development is incorporated as an incubator with the objective to design and implement scalable and sustainable risk- and investment solutions for frontier markets. Cardano Development has the managerial and organizational structure to explore new opportunities. Second, the people involved share the same DNA, expertise and passion to build and offer these much needed solutions. We can leverage our technological and quantitative expertise to new markets.  Third, patience is required and mistakes are allowed in a not for profit maximizing environment. It is really hard to launch a successful new initiative. It takes persistence, dedication and hard work to get there and you need to accept that it can fail. Learning from failure is a very powerful process in trial and error progression. Finally projects need to have an autonomous structure, and be able to depend on sustainable resources.”

 “Cardano Development is fully committed to support innovative financial risk management business models with the goal to developing scalable sustainable finance markets.”

 Concluding remarks

Herman: “In general, I see two trends: 1) to finance development objectives private funding is targeted, and 2) commercial investments are more often made with specific impact targets. Institutional investors are becoming more interested in sustainable finance. A good example is the success of Green Bonds. Impact reporting is important to avoid green washing. Linking it to the new SDGs could be a catalyst to grow the market for sustainable finance. During my research, I use my practical knowledge to uncover new innovative approaches to bridge the development finance gap. I wish to use the insights that are gained to develop new tools and projects, which help to connect the development finance and private finance worlds.”  

The final results of the study will be published before the summer of 2016. People who are interested to read the full dissertation can always contact Herman Bril: brilherman@gmail.com


Exploring the role of Multilateral Development Banks and Development Finance Institutions in conjunction with capital markets, and how they can contribute to the funding need related to the new UN Sustainable Development Goals in emerging markets and developing economies

The finance gap and sources of finance

The recently agreed Sustainable Development Goals (SDGs) require in the order of $2-3 trillion per year additional funding for emerging markets and developing economies (EMDEs). The biggest sums are required for infrastructure, climate change, and agriculture. The sources of this finance are:

  • Public Domestic, Private Domestic;
  • Public International Concessional – Official Development Aid (ODA);
  • Other Financial Flows (OFF) provided by Multilateral Development Banks (MDBs) and Development Finance Institutions (DFIs); and
  • Private International such as Foreign Direct Investment (FDI).

EU Data in 2010 indicated that domestic public resources exceeded international public finance by a factor of 20. The latter was only 2% of the total finance available in EMDEs. Private finance was on a par with public finance.

Private finance is needed to fill the gap

While the Millennium Development Goals focused primarily on public investment needs for ending extreme poverty, the SDGs pursue a broader agenda that includes investments in sustainable agriculture, infrastructure, urban development, climate change mitigation, and other areas that can be financed through private means. Overall, the bulk of financing for sustainable development can and therefore should originate from private sources. The world has ample savings – estimated at $22 trillion per year with a stock of financial assets of some $218 trillion (UN 2014) – and liquidity to finance the private investments in the SDGs. Yet private financing remains vastly insufficient. A central question is therefore how global savings can be translated into the long-term private investments that the world needs in the pursuit of sustainable development. In essence this will require that sufficient sustainable investment opportunities become available with a risk-return profile that is more attractive than the return for other ‘unsustainable’ investments. Private financing may come from institutional investors, corporations, banks, bond issuance, sovereign wealth funds, and other sources.

MDBs and DFIs should mobilize private finance more

The G20 in 2013 stated that “Long-term financing is critical for investment and necessary to fuel longer-term global growth. Its availability and composition has been affected by a combination of factors, some related to the global financial crisis and cyclical weaknesses in parts of the global economy, others related to structural factors and/or longer-term trends. All major categories of long-term financing debt flows, bank lending, bonds, portfolio equity and FDI have been affected, but to different degrees and in different ways”. With limited direct lending capacity going forward, and the fiscal constraints of many of their major shareholders, there is a need to ensure that the catalytic role and potential of MDBs and DFIs in mobilizing long-term investment financing is fully utilized. Maximizing the impact of public resources on growth, and financial and private sector development, requires demonstrating meaningful “additionality”.

MDBs and DFIs are constrained and face multiple masters

MDBs and DFIs have two sets of ‘principals’: the overt political and financial owners of these development institutions – government shareholders with sometimes conflicting objectives and unequal voting rights – and the suppliers of finance provided by bond investors. The former tout their activities to promote development while the latter other pay close attention to their balance sheets and profitability. Also, this financing model has afforded development institutions more operational autonomy from shareholders. The MDBs and DFIs have no formal regulator but are effectively constrained by private sector Credit Rating Agencies (CRAs). The external pressure and attention in the aftermath of the financial crisis in 2008 has led the agencies to revamp their methodologies for evaluating different classes of investments, including development institutions, and have become an increasing constraint on MDB and DFIs’ operational capacity. The revised CRA methodologies implemented after 2012 have restricted the development institutions even further, making it more difficult for them to meet the call of the G20 and others to ramp up development operations without a major increase in shareholder capital, despite their very high financial security. Callable capital was created to give MDBs and DFIs greater financial security, but in practice it has led many development institutions to be even more conservative than they might be otherwise, pushed by shareholders to ensure that callable capital never will be called.

Financial innovation and desintermediation are possible solutions

Faced with shareholders who are unwilling to provide material additional paid-in capital, the demand for AAA rating by bond holders and constraint by CRAs is pushing MDBs and DFIs to explore other ways to contribute to increased SDG finance demand:

  • Restricting lending to sovereign borrowers viewed by CRAs as highly risky, as a way to limit the impact on risk-weighted assets and single-exposure concentration penalties.
  • Intensive reverse engineering of CRA evaluations to better understand the impact of individual factors.
  • Building capital buffers to ensure sufficient distance from downgrade triggers, thus protecting against uncertainty in CRA criteria.
  • Designing exposure exchange arrangements among MDBs and DFIs, wherein they synthetically exchange individual country exposures while maintaining their overall asset risk profile, thus reducing the impact of single-exposure concentration penalties.
  • Ramping up techniques for removing exposures from the balance sheet, notably through loan syndication and co-financing arrangements.
  • Exploring other options for reducing balance sheet risk, such as purchasing market-based insurance on an individual exposure or portfolio basis, and portfolio guarantees with bilateral donors.
  • Leveraging concessional lending windows as a way to build more equity capital.

These forms of financial innovation and desintermediations are predictable rational behaviour from financial institutions who want to survive and grow, are resource constrained, seeking more independence from their owners with sometimes conflicting agendas and facing multiple ‘masters’.

The 2015 G20 Summit – MDBs’ action plan to optimize balance sheets

Already in 2013 the G20 began calling on MDBs to work through their Boards to optimize balance sheets, in order to increase lending without substantially increasing risks or damaging credit ratings. However, it was made clear that any incremental MDB operations would have to be done in a manner consistent with existing debt sustainability frameworks, and in respect of the MDBs’ full set of governance processes. Beyond the immediate optimization of their own balance sheets, MDBs should continue to advance their engagement with the private sector and to further explore how limited public resources can be used to leverage additional private finance.

Debt financing and capital markets

MDB and DFI operations do not come close to filling the gap between SDG related funding needs and public and private sector financing. They are very ambitious in seeking an important role, and the international agenda has increasingly called for MDBs to scale up their activities, in conjunction with private sector actors. Numerous techniques are available for finance development institutions within their balance sheet constraints to engage in leveraging, including targeted investments, guarantees, loan syndication, and co-financing arrangements.

Debt financing will form the bulk of SDG investments in cooperation with the private sector, and the first option for MDBs and DFIs is to play a substitution role for debt capital markets. Since 2013, European banks in particular have been more active again in the project finance arena, including starting to work with institutional investors on ‘originate to distribute’ loan-to-bond financing deals. However, these have so far been limited to developed economy projects. The possibilities of ‘loan to bond’ structures to facilitate institutional investors’ involvement in infrastructure financing in EMDEs is a topic for further investigation, according to the literature research. Other suggestions in the literature related to capital markets are, for example, to create a more effective secondary market, which could draw in more infrastructure financing from institutional investors who typically do not take on planning, construction, and other risks for new infrastructure projects but like to invest in operational facilities. It would allow banks to recycle their capital more effectively. To ensure effective recycling of bank capital, much more needs to be done to standardize infrastructure investments and pre-plan bond refinancing as part of initial infrastructure finance plans and national public investment systems, strengthening de-risking tools from the MDBs and DFIs and currency hedging instruments like The Currency Exchange Fund – jointly owned by leading MDBs and DFIs to promote local currency financing. Moreover, investment banks and development institutions can do more to enhance the securitization of (infrastructure) investments according to the needs of institutional investors.

More research is required

We need better insight into MDBs and DFIs as financial intermediaries operating in financial markets. The aim is to understand better how these financial development institutions can leverage their role with limited capital and mobilize institutional investors to reduce the funding gap related to SDG funding needs. Capital market techniques are a possible solution to tap into the global savings primarily managed by institutional investors such as, for example, pension funds and insurance companies in developed countries.

I will conduct this research project as part of my dissertation for Master of Studies in Sustainability Leadership at the University of Cambridge, and as feasibility study for Cardano Development Foundation (incubator of innovative concepts to strengthen the financial market infrastructure in developing countries).

The results of this research will be published after completion, which is expected in July 2016.


Herman Bril is Managing Director at Cardano Risk Management Limited in London. He is also Non-Executive Chairman of TCX Fund Manager (TIM), and was Director at Cardano Development from 2010-2014.

Clean cookstoves, easier said than done

The biggest potential gains in global welfare and environmental conditions would come from ‘cleaner cooking’, for the 2.5 billion people at the bottom of the pyramid who still rely on traditional cooking stoves[1].

Household cooking on open fires is very problematic

Most of the poorest people, in low- and middle-income countries mostly, still rely on solid fuels (wood, animal dung, charcoal, crop wastes and coal) burned in inefficient and highly polluting stoves for cooking and heating. Searching for and using solid biomass puts women and children’s safety at risk; depletes forests, which can weaken soil causing mudslides and destroying agricultural land; and jeopardizes human health and household and community air quality through toxic smoke emissions. In 2012 alone, no fewer than 4.3 million children and adults died prematurely from illnesses caused by household air pollution (HAP).  Black carbon, which results from incomplete combustion, is estimated to contribute the equivalent of 25-50% of CO2 warming globally. Methane emissions are the second largest cause of climate change after carbon dioxide. Limiting climate change would require substantial and sustained reductions in greenhouse gas emissions which, together with adaptation, can limit climate change risks.

Clean Cook Stoves could be the solution

If appropriately designed and disseminated, improved clean cook stoves can reduce a large share of emissions from cooking with biomass. These reductions also bring other benefits, such as reduced indoor and outdoor pollution, less pressure on forests, and economic and time savings due to the reduced need to search for or purchase costly fuels. The most effective way to reduce HAP is to switch to cleaner fuels, and by promoting improved cookstoves. This is based on evidence of climate co-benefits of cleaner household fuel combustion and opportunities for carbon finance. However creating meaningful impact requires scale to reach millions of households in developing countries to adaption and sustained use of clean cookstoves.

Targeting the Base of the Pyramid customers

It is important to understand the general difficulties to pioneering new business models to serve and benefit the poor in developing countries. The most obvious factor is that the poor have much less money, which make them much more risk-averse[2]. The poor are more likely than other people to make bad economic decisions, because they are more likely to lack the basic information needed to make good choices[3]. They also are more likely to live in societies which hold mistaken or harmful views[4]. The poor can be much more risk adverse because poverty makes people feel powerless and blunts their aspirations, so they may not even try to improve their lot[5]. When they do, they face obstacles everywhere, so they have no margin for error. They are therefore less likely to spend their money on unfamiliar products like clean cookstoves. In addition they are less well informed about available solutions to their needs, because they do not have access to the same information channels and resources, and because they tend to be less well educated[6].

Adoption and sustained use of cook stoves

Clean coostove adoption faces some of the greatest challenges as less than 30% of biomass stove users globally cook with some form of an improved clean stove[7].  Evidence from clean cookstoves in Burkina Faso[8] also confirms that so far improved cookstoves have not made inroads into households in developing countries. In particular in Africa, take up rates are generally very low and even market based programs have difficulties in achieving sustainable usage in their target areas. In spite of obvious advantages of using clean stoves, adoption rates were very low at only 10%, although the improved stoves are widely available. Improved clean cookstoves are a clear example of a push product[9]. Most customers are unaware of the problems of HAP. So not only is the value of clean stoves not clearly and readily apparent to target consumers, but using these products also often involves changes to established cooking practices in the home. Research concluded that decades of initiatives focusing on clean stoves in India – led by government, NGOs international donors and even multinational corporations – have not succeeded in driving widespread adoption[10].

Factors that make cook stoves projects successful or not

No matter how effective a stove is in terms of reduced emissions, health and climate benefits will not be achieved if it is not used exclusively and continued over time. In households with an clean cook stoves, there often is incorrect, inconsistent, and non- exclusive use[11]. It is therefore very important to understand the factors that make improved cookstoves projects succeed or fail for sustainable adoption and large scale uptake.  Clean cookstoves must meet consumer needs and preferences if they are to lead to correct and consistent use and to successfully displace traditional stoves. However, consumer needs and preferences are complex and are influenced by many contextual and social factors that require a deep understanding of culture, going beyond technology and economics. Successful improved clean cookstoves business models will need to be sensitive to cultural practices in both the design of the product and marketing strategies, and many other factors are relevant according to field studies[12].

The Homo Economics does not exist

The Global Alliance for Clean Cookstoves published the following quote in their marketing research study[13]: The Case for Market Research in the Clean Cooking Sector. “For many years, a common response to the negative health, environmental, and socio-economic impacts of cooking on traditional stoves with solid fuel was to focus on technological solutions: designing stoves to optimize combustion and efficiency. User needs and preferences were often secondary considerations. Potential users of clean and efficient stoves were seen as beneficiaries instead of consumers, especially in cases where stoves were heavily subsidized or given away, rather than selected by consumers to suit their needs. Many programs attempted to motivate purchase and use of clean and efficient stoves and fuels by “educating” the poor about the negative impacts of traditional stove use. They emphasized the benefits of new technologies that aligned with development community values, such as reduced health and environmental impacts. Yet the evidence rarely showed that these benefits aligned with consumer values and led to increased demand and sustained use of better technologies. Understanding user needs and wants is now understood as critical to success in the clean cooking sector. It has become increasingly clear that the benefits of clean cooking cannot be realized unless consumers see technologies as desirable products that deliver an improved cooking experience and add value to their lives. In addition, there is increasing evidence that fully realizing the health benefits of clean cookstoves and fuels requires nearly complete displacement of traditional stoves by households. This evidence makes the development of products that fully meet consumer needs even more critical. There is also increased acknowledgment that base of the pyramid (BoP) consumers do not represent a homogeneous market, but instead consist of distinct market segments with diverse needs and motivations”.

Clean cooking is not easy but extremely important.

Happy cooking.

Herman Bril


The blog is based on my research paper: “Addressing scalability and carbon financing for sustainable clean cook stoves for Base of Pyramid consumers in developing countries”, 2015; CISL

[1] Michael Grubb; Planetary Economics; 2014

[2] http://www.economist.com/news/finance-and-economics/21635477-behavioural-economics-meets-development-policy-poor-behaviour

[3] http://www.worldbank.org/en/publication/wdr2015

[4] See footnote 2

[5] See footnote 3

[6] http://www.beyondthepioneer.org/

[7] http://www.ghspjournal.org/content/2/3/268

[8] http://en.rwi-essen.de/publikationen/ruhr-economic-papers/633/

[9] See footnote 6

[10] https://www.shellfoundation.org/ShellFoundation.org_new/media/Shell-Foundation-Reports/shell_founation_social_marketing_in_india.pdf

[11] http://www.ghspjournal.org/content/2/3/268

[12] http://ehp.niehs.nih.gov/1306639/

[13] http://cleancookstoves.org/resources/411.html


How sustainable is finance?

Finance should support and facilitate a prosperous society but after 2008 it became clear that society supports a prosperous finance industry.

It is easy to question the role of financial activity. After all, between January 2012 and December 2014, financial institutions paid $139bn in fines to US enforcement agencies. More fundamental is the contrast between the 7 per cent average share of the financial sector in US gross domestic product between 1998 and 2014 and its 29 per cent average share in profits, according to Marin Wolf (FT May 26).

In this year’s presidential address to the American Financial Association, Luigi Zingales asked “Does Finance Benefit Society?”. He concluded that “at the current state of knowledge there is no theoretical reason to support the notion that all the growth of the financial sector in the last 40 years has been beneficial to society”. And a recent paper from the Bank of International Settlements, the central bankers’ central bank, concluded that “the level of financial development is good only up to a point, after which it becomes a drag on growth”.

The finance sector damages the economy because it does not function as well as the models contend. Asset bubbles can and do form. Buyers of debt fail to prudently assess whether the borrowers can repay. The incentives that govern the actions of financial sector employees tend to reward speculation, rather than long-term wealth creation. Some of this is to do with the way that governments have regulated the financial system. But much of it is to do with the psychological foibles that make us human. A good actual example is China, it’s fast-growing middle class absolutely loves playing the stock market. Chinese families are opening accounts and borrowing money to trade on margin at an astonishing pace. Not surprisingly the stock market went completely crazy this year. But what goes up must go down and the Chinese markets continued to fall this week, down by 30% from their previous rise in less than two weeks!

The Economist published a brilliant article, “What’s wrong with Finance” (May 1), and is summarized below.

Traditional finance theories still hold sway in academia because they look good in textbooks; they are based on mathematical formula that can be easily adapted to analyse any trend in the markets. “Theorists like models with order, harmony and beauty” says Robert Shiller of Yale, who won the Nobel prize for economics in 2013. “Academics like ideas that will lead to econometric studies.” By contrast, economists who speak of the influence of behaviour on markets have to use fuzzier language, and this can seem unconvincing. “People in ambiguous situations will focus on the person who has the most coherent model” adds Mr Shiller.

Markets display a herd mentality in which assets become fashionable. Investors pile in, driving prices higher and encouraging more investors to take part. Charles Kindleberger, the economic historian, said that “There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.” If other people are making a fortune by buying tech stocks, or by trading up in the housing market, then there is a huge temptation to take part, in case one gets left behind. This herd mentality means that financial assets are not like other goods; demand tends to increase when they rise in price. To the extent that investors worry about valuations, they tend to be extremely flexible; expectations of future profits growth are adjusted higher until the price can be justified. Or “alternative” valuation measures are dreamed up (during the internet era, there was “price-to-click”) that make the price look reasonable. When confidence falters, there are many sellers and virtually no buyers, driving prices sharply downwards. Indeed, in 2008, assets that had not previously been correlated with each other all fell at once, further confounding the banks’ models of investment banks. Assets that were supposedly safe (like AAA-rated securities linked to subprime mortgages) fell heavily in price.

When this happened with dotcom stocks in 2000-2002, the problem was survivable. Some technology funds lost 90% of their value but, for most investors, such funds formed only a small portion of their savings. The problems became more intense with subprime mortgages because the owners of such assets were leveraged; that is, they had financed their purchases with borrowed money. They were forced to sell to cover their debts. And when some could not cover their debts, confidence in the whole system broke.

Leverage was a factor that was not really allowed for in mainstream economic models. To economists, debt is important to the extent that, in a sophisticated economy, it allows individuals to smooth their consumption over their lifetimes. For every debtor, there is a creditor, so a loss to one side must be offset by a gain to another; net global debt is always zero.

What is the finance sector supposed to do?

Essentially, it needs to perform a number of basic economic functions. First and foremost, it operates the payments system without which most transactions could not occur. Secondly, it channels funds from individual savers to the corporate sector so the latter can finance its expansion. In doing so, it does the highly useful service of maturity transformation; allowing households to have short-term assets (deposits) while making long-term loans. It also creates diversified products (such as mutual funds) that help to reduce the risk to savers of catastrophic loss. Thirdly, it provides liquidity to the market by buying and selling assets. The prices established in the course of this process are a useful signal of which companies offer the most attractive use for capital and which governments are the most profligate. Fourthly, the sector helps individuals and companies to manage risks, whether physical (fire and theft) or financial (sudden currency movements).

But the problem is that the basic utility functions of banking (payments, corporate lending) are boring and not that profitable. The big money has been made elsewhere. In their paper for the BIS, Stephen Cecchetti and Enisse Kharroubi show that rapid growth in the finance sector tends to a lead to a decline in productivity growth. Two factors may be at work. First, the high salaries offered in finance divert the smartest graduates away from other sectors of the economy. Second, bankers prefer to lend against solid collateral, in particular property; periods of rapid credit growth tend to be associated with property booms. But construction and property are not particularly productive sectors. The net effect is that resources are diverted away from the most productivity-enhancing sectors of the economy.

In his speech, Luigi Zingales cast doubt on some of the finance sector’s other services. “There is remarkably little evidence that the existence or the size of an equity market matters for growth” he said, adding that the same is true for the junk bond market, the options and futures market or the development of over-the-counter derivatives. That raises the uncomfortable possibility that a lot of the finance sector’s returns may be down to the exploitation of customers.

Regulators have tried to tackle some of these issues by insisting that banks hold more capital on their balance sheet, to make them less vulnerable to plunging asset prices. The rules also mean that banks devote less capital to trading. But these approaches run into the St Augustine problem, who proclaimed “Lord, give me chastity, but not yet.” The efforts of the banks to improve their capital base has made them chary about lending to business, thereby slowing the recovery. Their retreat from market-making has made financial markets less liquid; some fund managers fear the next crisis may occur in corporate bonds, which investors have bought in search of higher yields. When investors try to sell, the banks will be unwilling to offer a market, causing prices to plunge; some funds may be forced to suspend redemptions, leading to a crisis of confidence.

Another regulatory approach is to focus on “macro-prudential policy”. One of the reasons central bankers were reluctant to tackle high asset prices was that their only tool was interest rates. But higher rates would damage the rest of the economy, as much as it would tackle market excess. A more sophisticated approach would use other tools, such as restricting the ratio of loans to property values. At the peak of the boom, no deposits were required. But it remains to be seen whether regulators will have the willpower to use such tools at the top of the next boom or indeed whether eager homeowners will find ways round the rules, for example by borrowing from unregulated lenders.

What about the response of economists? There has been a lot of work in recent years about the role of debt including, most famously, the studies of Carmen Reinhart and Kenneth Rogoff. Unfortunately, this debate has been sidelined on to the narrow issue of the level of government debt rather than the aggregate level of debt in the economy. Iceland and Ireland did not have a lot of government debt before the crisis; it was their bank debt that caused the trouble.

The use of quantitative easing (QE) to stabilise economies has made it a lot easier to service debts and indeed has prompted many to argue that deficits are irrelevant in a country that borrows in its own currency and has a compliant central bank. Very little of the pre-crisis debt has been eliminated; it has just been redistributed onto government balance sheets. But QE has also forced up asset prices, boosting the wealth of the richest, and making it even more difficult for central banks to reverse policy.

Even now, many years after the crisis, and with their economies growing and unemployment having fallen, the Federal Reserve and Bank of England have yet to push up rates. Perhaps they will never be able to return rates to what, before the crisis, would have been deemed normal levels (4-5%) nor indeed will they be able to unwind all their asset purchases. So we have ended up, after three decades of worshipping free markets, with a system in which the single most dominant players in setting asset prices are central banks and in which financiers are much bigger receivers of government largesse than any welfare cheat could dream about. Economic and financial theory have not adjusted to this situation.

For too long economists ignored the role that debt and asset bubbles play in exacerbating economic booms and busts; it needs to be much more closely studied, as concluded in the Economist.

So what is to do be done? Here are a few preliminary answers according to Martin Wolf (FT May 26).

First, morality matters. As Prof Zingales argues, if those who go into finance are encouraged to believe they are entitled to do whatever they can get away with, trust will break down. It is very costly to police markets riddled with conflicts of interest and asymmetric information. We do not, by and large, police doctors in this way because we trust them. We need to be able to trust financiers in much the same way.

Second, reduce incentives for excessive finance. The most important incentive by far is the tax deductibility of interest. This should be ended. In the long run, many debt contracts need to be turned into risk-sharing contracts.

Third, get rid of too big to fail and too big to jail. These two go together. The simplest way to get rid of too big to fail would be to raise the equity capital required of global systemically important financial institutions substantially.

Many would then choose to break themselves up. Once that has happened, fear of the consequences of prosecution should also diminish. Personally, I would go further by separating the monetary from the financial systems, via the introduction of “narrow banking” — that is, backing demand deposits with reserves at the central bank.

Finally, everyone has to understand the incentives at work in all such “markets in promises”. These markets are exposed to corruption by people who do not care whether promises are kept or whether counterparts are even unable to understand what is being promised.

How sustainable is finance? We still have a long way to go…

Herman Bril

There is a cure for the original sin

The headlines last week:

‘The rise of the dollar will punish borrowers in emerging markets’ (http://www.economist.com/news/leaders/21646749-rise-dollar-will-punish-borrowers-emerging-markets-mismatch-point?frsc=dg%7Ca); ‘IMF fears emerging markets instability’ (http://www.ft.com/cms/s/0/e14253ba-cc9d-11e4-b94f-00144feab7de.html#axzz3VQwWwtoZ).

The head of the International Monetary Fund warned on Tuesday that emerging markets are set to face a renewed period of economic instability when US interest rates rise this year, forecasting a repeat of 2013’s damaging “taper tantrum” episode of capital flight and rapid currency depreciation.

In the past three months the dollar jumped by 11% and over the past year 22%, its fastest ascent in decades. Companies around the world, and especially in emerging markets, have been bingeing on dollar-denominated debt, seduced by the lower interest rates on offer compared with local-currency debt. The stock of dollar debts owed by non-financial borrowers outside America has grown by 50% since the financial crisis, according to the Bank for International Settlements. It now stands at $9 trillion. Emerging markets account for half of that amount, up from a third before the crisis. In China alone, dollar-denominated loans have vaulted from around $200 billion in 2008 to more than $1 trillion now. As the dollar rises, this debt becomes more expensive to service in local currency. And as the Fed starts to tighten, the interest rates charged on dollar debts—whether in bond markets or via banks—will rise in tandem. As a result, borrowers are at risk of a double whammy: a strengthening dollar and a rising cost of borrowing and refinancing.

Economist call this the “Original sin”: The original sin hypothesis was first defined as a situation “in which the domestic currency cannot be used to borrow abroad or to borrow long term even domestically” by Barry Eichengreen and Ricardo Hausmann in 1999. Based on their measure of original sin (shares of home currency-denominated bank loans and international bond debt), they showed that original sin was present in most of the developing economies. (http://en.wikipedia.org/wiki/Original_sin_%28economics%29).

Over many decades we have seen the same story over and over again, (emerging) countries, companies and households (50% of the Hungarian mortgages are denominated in Swiss Franc or EURO’s) borrow in hard foreign currencies covered by income in local currencies. Why? The interest rate in hard foreign currencies is lower than the domestic rates.  This is called currency mismatch risk. When things are relatively stable for a while, people become overconfident that ‘this time it will be different’ and enjoy lower debt servicing costs until they get hit by a financial Tsunami. A massive depreciation of the local currency as result of an economic shock and the debt (expressed in local currency) is ballooning and…..they default.  We call this process Boom, Bust, Boom (see our website http://www.boombustclick.com/thebigidea.php).

What’s the solution? Well that’s pretty simple: local currency financing. Switching from foreign to local currency funding in emerging and frontier markets has important positive effects at the micro- and macro-economic levels.

If it’s so simple, why is it not happening? Most banks and Development Finance institutions (DFI’s) lent money only in hard currencies to their clients in emerging or frontier markets because they don’t have appetite to bear the currency risk. So they transfer currency mismatch risk to their clients and call it counterparty risk (this is the risk that the borrower is unable to repay the loan).

In 2007 the Dutch DFI FMO and Cardano came with a very simple but extremely effective financial innovation to help to solve the problem of the original sin: the launch of The Currency Exchange Fund (https://www.tcxfund.com/)

The Currency Exchange Fund (TCX) provides OTC derivatives to hedge the currency and interest rate mismatch that is created in cross-border investments between international investors and local borrowers in frontier and less liquid emerging markets. The goal is to promote long-term local currency financing, by contributing to a reduction in the market risks associated with currency mismatches. To achieve this objective, TCX acts as a market-maker in currencies and maturities not covered by commercial banks or other providers, notably where there are no offshore markets, no long-term hedging, or, in extreme cases, no markets at all. This activity spans 70 currencies in Sub-Saharan Africa, Eastern Europe, the Middle East & North Africa, Central Asia, South East Asia, and Latin America. TCX is usually unable to hedge itself. The core risk management principle is the risk-reducing effect of running a globally diversified pool of currency exposures. This is supported by a conservative capital base provided by patient investors and donors. TCX’s investor base predominantly consists of development finance institutions and microfinance investment vehicles active in the long-term debt markets of emerging and frontier markets.

Since 2007, TCX has contributed to the reduction of currency mismatches on the books of emerging and frontier market borrowers by absorbing their currency risk through more than $1.5 billion in FX forwards and cross-currency swaps, spread across 400+ trades in 46 currencies.

By enabling international lenders to offer long-term debt in local currency, TCX helps reduce the excessive reliance on short-term debt that characterizes lending in frontier markets especially. This lowers the probability of self-fuelling rollover / liquidity crises, supports long-term financial inflows mainly from development finance institutions, contributes to an overall strengthening of the balance sheets of corporate and financial institutions, and enhances the resilience and growth potential of emerging and frontier economies.

Helping these markets to acquire the capacity to borrow long-term both locally and abroad in their own currencies should be a priority for officials striving to make the world a safer financial place, and seeking to quicken the pace, sustainability and resilience of growth. A noteworthy benefit is it creates more room for implementing macro-economic policy adjustments without adversely impacting growth and stability.  (Recommendation of the European Systematic Board of 21 September 2011 on lending in foreign currencies – ESRB/2011/1)

The cure for the original sin is local currency financing, the recipe for sustainable finance and resilience.

Fifty shades of green bonds

Don’t worry this blog does not contain any erotic language but is about fixed income bonds. However bonds are not dull or boring investments and since 2008 there are even ‘sexy’ green or climate bonds. Greenness aside, such bonds are indistinguishable from any other investment-grade “plain vanilla” security. They carry no extra costs: investors are not exposed to the risks in the projects that are funded by the bonds. Nor do they profit if those projects, which typically include renewable-energy initiatives and reforestation schemes, do well. So why bother to invest at all? The proceeds are invested in environmentally friendly project, so besides a financial return, a social/environmental return is embedded too for investors. The first green bond was issues by the World Bank in 2008 and the market has developed rapidly to an outstanding notional of about $40 billion. During the first four years of its existence, the green bond market was dominated by a few multilateral institutions and development banks. Corporate issuers have only recently entered the market, but have contributed in an impressive way to its exponential growth. Since France’s Air Liquide launched its “social” bond in October 2012, twenty-five corporate green bonds have been issued, together amounting to over $13 billion.

The Economist published in 2011 (Climate Bonds, A dull shade of green; a modest, but important, addition to climate finance; http://www.economist.com/node/21534810 ) the following: “Reducing the risks of climate change is not a technological problem. There are many ways to generate electricity, drive cars or grow crops without emitting much carbon dioxide—but they are expensive. According to the International Energy Agency, $13.5 trillion must be invested in low-carbon energy by 2035 to reduce emissions. That sort of money can be found only on capital markets. Yet investors’ appetite for green schemes is unproven”. But there’s a lack of standardization, too, including 11 different names for “green bonds”. And what constitutes “greenness”, or the risk of green washing? To grow this market successfully we should avoid a very “pale” green one – where the lowest possible hurdle rates/standards have been used to determine “greenness” and the market becomes pool of bonds with low environmental impact but high PR value. Although a consortium of leading investors has recently put together Green Bond Principles (“GBP”), these are voluntary.

Is it green? A few questions (www.responsible-investor.com ; Green Bonds: the future of sustainability financing) to address the issue;

  • The issuer has listed several categories of eligible green projects” in its pricing supplement, but are all those categories really green?
  • Will the issuer really spend the money on green projects? Are the proceeds really “ring-fenced”?
  • Will the issuer actually report to the public on which projects received the proceeds?
  • Does the issuer have a second party opinion?
  • Are bonds issued by a “pure green” company or project or pool of loans automatically green bonds?

To tackle these issues the GBP Voluntary Process Guidelines for Issuing Green Bonds were published in 2014 (www.icmagroup.org/greenbonds), and contained the following four components:

  1. Use of Proceeds
  2. Process for Project Evaluation and Selection
  3. Management of Proceeds
  4. Reporting

They also included a paragraph about assurance in order of increasing rigor, and gave the following suggestions:

  • Second party consultation
  • Publicly available reviews and audits
  • Third Party, independent verification/certification (i.e. like the voluntary carbon credit market)

If you read the details of the GBP it becomes clear that this might be very cumbersome and expensive for issuers to be compliant with the principals. Corporates can also just issue normal bonds without the hassle and pay exactly the same coupon. Alternatively they can communicate their “greenness” via their Sustainability Reporting. The same can be said about institutional investors, besides the normal credit research the analyst and portfolio manager needs to do, it is a lot of work to determine if the green bond passes the test of risk/return and GBP (or ESG/SRI) criteria (which is part of their fiduciary responsibility). This could seriously hamper the growth from a marginal market to a mainstream market.

A possible solution is to introduce Green Ratings next to Credit Ratings. A credit rating is an evaluation of the credit worthiness of a debtor, especially a company or a government. The evaluation is made by a credit rating agency of the debtor’s ability to pay back the debt and the likelihood of default. The credit rating represents the credit rating agency’s evaluation of qualitative and quantitative information (including climate risks) for a company or government; including non-public information obtained by the credit rating agencies’ analysts. Credit ratings are not based on mathematical formulas but credit rating agencies use their judgment and experience in determining what public and private information should be considered in giving a rating to a particular company or government. The credit rating is used by investors that purchase the bonds issued by companies and governments to determine the likelihood that the government will pay its bond obligations. A poor credit rating indicates a credit rating agency’s opinion that the company or government has a high risk of defaulting, based on the agency’s analysis of the entity’s history and analysis of long term economic prospects.

Although credit rating agencies were bashed – rightly so – after the 2008 financial crisis (because of flawed statistical models which did not assume the possibility that housing prices could decline materially, and a conflict of interest issue because only the issuer is paying the credit rating fee), the principle of a applying a third party issuing a Green rating seems efficient and effective at first sight (assuming both issuer and investor are paying for the service, and the provider is using a rigorous methodology for deriving Green ratings).

The three main credit rating agencies use the following labels to communicate their credit assessments.


Green Ratings could apply a comparable methodology and labeling to express the “greenness” of the issuer or bond. I am not sure if we end up with “fifty shades of Green”, but the market needs more standardization and differentiation to evolve and become mature. The bond market cannot operate without credit ratings, because many institutional investors have credit rating guidelines in their investment policies.

More research, thinking and debate needs to be done to understand if and how Green Ratings are possibly the Holy Grail for unlocking  the necessary growth of the Green bond market to fund the trillions needed to invest in renewable energy, energy efficiency, sustainable waste management, sustainable land use, biodiversity conservation, clean transportation and clean water.

Mind, Society and Behaviour

The World Bank just released a new report “Mind, Society and Behaviour”, to inspire and guide researchers and practitioners who can help a new set of development approaches based on a fuller consideration of psychological and social influences (Gauri, 2014). The idea is that paying attention to how humans think (the processes of mind) and how history and context shape thinking (the influence of society) can improve the design and implementation of development policies and interventions that target human choice and action (behaviour). To put it differently development design is due to for its own redesign based on careful consideration of human factors.

If you are not trained as a neoclassical economist who believe in the model of the wholly rationality-driven “economic man”, this may not sound so radical or strange. But standard economics, taught so prominent for so long in economic courses at all the leading universities,  places human cognition and motivation in a “black box”, by using models that often assume that people consider all possible costs and benefits from a self-interested perspective and then make a thoughtful and rational decision. Still today this flawed thinking is mainstream at Central Banks, leading policy makers and also in the world of development.  But this school of thinking (and acting based on mathematical models) ignores the psychological and social influences on behaviour. Individuals are not calculating automatons, as explained by Yannis Papadogiannis in his book: “The rise and fall of Homo Economicus, the myth of the rational human and the chaotic reality” (2014). Rather, people are malleable and emotional actors whose decision making is influenced by contextual cues, local social networks, and social norms and shared mental models. In short human behaviour is a mix of ‘nature and nurture’ as wonderfully described in “Happiness, the best is yet to come” (2014) by Don Ezra (a financial economist). You can watch his presentation on Vimeo http://vimeo.com/88365541. If you would like to explore this topic in more detail, I highly recommend reading the work of the ‘god father’ of behavioural economics, Daniel Kahneman. He shared the 2002 Nobel Prize in Economic Sciences with Vernon Smith. His latest publication was Thinking, Fast and Slow (2013) which was a global bestseller, and had profound impact on psychology and economics. (See also article in the Guardian http://www.theguardian.com/science/2014/feb/16/daniel-kahneman-thinking-fast-and-slow-tributes and his TED talk http://www.ted.com/talks/daniel_kahneman_the_riddle_of_experience_vs_memory?language=en ).

The Economist (December 6th-12th, 2014) published an article ‘Poor behaviour’ http://www.economist.com/news/finance-and-economics/21635477-behavioural-economics-meets-development-policy-poor-behaviour referencing the World Bank Report and mentioned: “making this the subject of its main annual publication, the Bank has brought behavioural economics into the mainstream of development. It is likely to prove a challenge to traditional ways of combating poverty, as well as a complement to them”.

This is a welcome, important and necessary step because the history of scientific revolutions shows that that the leaders of a field almost always resist new ways of thinking, whereas younger students and interested laymen are often receptive to new ideas, as pointed out convincingly by George Cooper (2014) in his book “The origin of financial crises: money, blood and revolution; how Darwin and the doctor of King Charles I could turn economics into a science”. Richard Feynman (1918-1988) once said: “It doesn’t matter how beautiful your theory is, it doesn’t matter how smart you are. If it doesn’t agree with experiment, it’s wrong”.  That sounds pretty obvious but Thomas Kuhn explained in his famous book “The Structure of Scientific Revolutions” (1962) that the problem he found was that the way we analyse and interpret the world and look at experimental data is intimately entwined with our existing, pre-conceived understanding of how the world works, which he called incommensurability. In other words, in economics it is quite common for people to agree about the data but disagree entirely about what the data means, according to George Cooper.

I strongly believe that behavioural economics is extremely relevant for finance, development, policy making and sustainability. Ideas 42 (www.ideas42.org ), a non-profit design lab and consulting firm that applies insights from behavioural science to complex social problems, uses behavioural economics to social good and have impact at scale. Below I have listed a few of their behavioural principles as posted on their website:

Limited attention affects the decisions people make. When attention is stretched, people have a difficult time focusing on both the benefits and consequences of options. Being aware of these attentional limits allows us to make changes that mitigate their negative consequences. Setting default options or forcing choices that require individuals to stop and consider the pros and cons of choosing an alternative can refocus their attention.

Status quo bias: This memorable quote from The Wizard of Oz sums up how many of us feel about home—it’s comfortable and familiar. But beyond the physical place, people consider other things “home” too, sometimes unconsciously: beliefs, previous choices, set routines. These things form an individual’s status quo, which people tend to prefer to stick to. As a result, people often “choose” pre-set options even when many others are available. As a result, even arbitrary options that set the status quo – for example, default settings – play incredibly important roles in decision-making, and can influence what people choose and what eventually happens.

Mental accounting: We often think of different bits of our income as falling into different buckets, each intended for a different purpose: the monthly bills account, entertainment funds, food money, and mortgage down payment fund. This has its uses: it can protect us from self-control issues, for instance by preventing us from spending too much of our pay check on tempting goodies. But there’s a flip side: the practice of viewing money as having specific labels can become generalized and cause us to behave in ways that are not in our best interest.

People procrastinate. They put off for tomorrow what they could (and want to) do today. These delays have real consequences: for example procrastinating on filing taxes costs an average of $400 in fees and unclaimed returns; putting off that health check may account for men’s higher death rates for preventable diseases. Farmers in the developing world procrastinate about making a trip to town to buy fertilizer – often resulting in none being used when planting season comes around. Procrastination is one of the ways in which self-control problems manifest themselves.

Prescriptive and Descriptive Norms: People usually have a good sense of what they should and shouldn’t do: do offer your seat to a pregnant woman; do wash your hands after you use the restroom; don’t double dip potato chips. But we don’t always follow these rules. Much the same is true of the decisions we make. We know what decisions we should be making, but sometimes we do something quite different. Yet often the messages we receive, especially for important decisions like retirement savings and organ donation, tend to focus on reminding us of what we should be doing. An alternative approach is to simply inform people of descriptive norms— what the majority of people actually do. In a review of twenty-one studies ranging from pertinent topics such as condom use, healthy eating, smoking and infidelity, researchers found that knowing what other people do is a stronger influence on how they eventually behave than knowing what society says they should do.

Choice overload: Too many choices can be overwhelming. When faced with a huge range of options, many people fail to choose the best option. Worse, they may fail to choose altogether. Too much information – a plethora of product features, combinations or specifications, for instance – can also have a similarly paralyzing effect on people’s decision making. An (over)abundance of options can mean that nothing is chosen.

Another very important principle, which was not mentioned by Ideas 42, is: overconfidence. This effect is a well-established bias in which a person’s subjective confidence in his or her judgements is reliably greater than the objective accuracy of those judgements, especially when confidence is relatively high (which is mostly the case for man), as described by Wikipedia http://en.m.wikipedia.org/wiki/Overconfidence_effect.

Going back to the World Bank report, they mention the following: from the hundreds of empirical papers on human decision making that form the basis of this Report, three principles stand out as providing the direction for new approaches to understanding behaviour and designing and implementing development policy. First, people make most judgements and most choices automatically, not deliberatively: we call this “thinking automatically”. Second, how people act and think often depends on what others around them do and think: we call this “thinking socially”. Third, individuals in a given society share a common perspective on making sense of the world around them and understanding themselves: we call this “thinking with mental models”.

My message for the readers of this blog post is perhaps controversial, but simple: according to Robert Roy Britt, humans are arguably the most bizarre creatures in the animal kingdom. The proof is in the many gross, unnecessary, contradictory and simply inexplicable things we do. And of course we’re different in our capacity to ponder all these oddities and sometimes figure a few out (http://www.livescience.com/4907-humans-strangest-species.html). So we just can’t ignore human behaviour and should incorporate this how we are learning, thinking and apply this in designing and implementing solutions to improve sustainable finance, development or any of the UN Millennium Development Goals for that matter, as promoted by the World Bank.

For the readers who are interested in this field, especially related to economics and finance, please see and join the debate at http://www.boombustclick.com/thebigidea.php , a Cardano Education initiative promoting the following: Boom Bust Boom proposes a simple idea – let’s adapt economics to human nature https://m.youtube.com/user/boombustclick.