Impact blog: Financial Innovation is no Frankenstein

Photo courtesy of maraisea.

Despite all the hype around fintech and cryptocurrencies, financial innovation still generates a particular degree of scepticism – not least among the millions plunged into poverty by the 2008 global financial crisis. For them and many others, the term “financial innovation” sparks memories of banks’ efforts to bundle a patchwork of questionable loans into an abstract and complex set of products, with names like “mortgage-backed securities” and “collateralized loan obligations.” This resulted in a 21st century Frankenstein’s monster that wreaked havoc across the global economy – with bankers playing the role of the mad scientist.

Nonetheless, financial innovation lives on – and it has brought both the investing world and the broader financial services sector to the cusp of a massive shift. It’s generating products and partnerships designed to deliver not only financial returns, but also positive impacts for both society and the planet. These innovations are making impact investing more accessible, helping it scale to such proportions that Wall Street is starting to pay attention. And impact investing products – often focused on financial inclusion – are being integrated into the largest of banks due to surging investor interest and sheer market demand – especially in emerging markets.

To take just one example: The World Bank has estimated that there is a credit gap of US $5-8 trillion for micro, small and medium enterprises (MSMEs) in emerging and frontier markets. Over the last decade, this clear demand for financial services has led to a surge in investment solutions that fund microfinance institutions and MSME banks in these markets. The resulting products are innovative and sizable, and they make a positive contribution to economic development. In their most recent investor survey, the Global Impact Investing Network (GIIN) found that respondents investing in microfinance and other areas of sustainable finance account for US $31 billion in assets under management (13% of the assets surveyed). What’s more, the survey shows that this sector has seen compound annual growth of 16% over the last four years. (Overall, impact investing is thought to account for US $502 billion – only half of which is covered in the GIIN survey.)

So investors are increasingly interested in sustainable investing in financial services, and demand in emerging markets is clear and substantial. Yet to continue scaling up assets and impact, further innovation will be needed to make these impact investing products accessible to a broader range of investors.

A great example of this type of innovation occurred recently, when responsAbility Investments, an impact investment asset manager, partnered with the Overseas Private Investment Corporation (OPIC, a U.S. government agency) and JP Morgan to launch a microfinance and MSME-finance collateralized loan obligation (CLO). Similar in structure to a bond, CLOs were viewed by many as the kind of financial over-engineering that contributed to the 2008 crisis. Yet in this instance, the product securitizes a portfolio of loans to 26 microfinance institutions, amounting to US $175 million. As part of this partnership, OPIC provided a partial guarantee for these loans, to reduce risk and catalyze private investment – an approach known as blended finance. This unique and innovative combination of financing will support organizations catering to 5.6 million microfinance borrowers in 17 different countries. Best of all, 81% of the borrowers from these organizations are female – a reminder that not only are many development issues particularly acute for women, but also that solutions to these issues are very attractive to investors who are keen to take concrete action towards women’s empowerment.

Deals like this help change the discussion from what finance should be, to what finance can be. It can be a place where blended finance unlocks previously untouchable markets to investors large and small. (Currently, Convergence estimates that the approach has mobilized over US $100 billion in investments.) It can be a place where finance institutions cater to those outside of a country’s financial or corporate elite, by providing loans to small businesses.

Microfinance isn’t perfect of course – like many fast-growing industries, it has seen a number of bubbles and regulatory crises. Nonetheless, by doing something that is still new in many countries – providing a relatively small range of products to excluded populations – micro and MSME finance remind us of the role financial innovation can play, when it’s leveraged for the benefit of customers. And in the next five years, new financial innovations will become available to tens of millions of customers who are excluded today, as the introduction of 3G and 4G networks in many emerging markets will pave the way for mobile microfinance. This will, in turn, reduce costs and allow further expansion into more remote areas, integrating the world’s most excluded populations – from coffee farmers in Peru to market traders in Mongolia – into the global financial system. It will also provide a vast array of opportunities to forward-thinking impact investors.

These developments show that financial innovation does not have to be a monster lurching towards the village, devastating the masses. On the contrary, the rise of successful new impact investing products that enable inclusive new financial services demonstrates that investors can make returns while supporting global sustainable development. Simply put, financial innovations can be a force for good, and investors no longer have to choose between their pensions and their principles.

Originally published on Next Billion.