The History and Future of Institutions for Long Finance

Much of the transition investment for a sustainable world will come from small scale business borrowing, drawing upon low-cost finance techniques dating back hundreds of years. For other investors, such as pension funds, share ownership or government bonds (investment for the common good) may be appropriate. Elsewhere innovative forms of finance, and innovative investment vehicles, may be required.

Sober Investments

That rather odd word ‘sober’ comes from Adam Smith’s Wealth of Nations. It may come as a surprise to some that the eighteenth century ‘Father of Economics’ did not approve of those who used accumulated capital (financial, land, or property) to generate income without working for it. He called them rentiers and would have taxed them heavily. Rather Smith thought that a nation’s wealth was created by the industrious working of “sober people” carrying out everyday business activities that were “most likely to make a profitable and advantageous use” of the “capital of the country” — what would now be called the ‘real economy’. The highest rates of such growth required modest interest on loans. But higher risk projects bearing higher rates of interest, or careless people prepared to pay such rates, would attract lending away from these sober needs. So Smith argued the interest should be around 5% per annum, and he regarded higher rates as usurious. Interestingly Piketty, in Capital in the Twenty-First Century, came to the identical conclusion, identifying rentiers as a major global challenge for the modern era, and also concludes that taxation is the best response.

Smith wrote what he did because lenders at that time generally sought far higher rates, among other faults, stifling growth. This was gradually resolved in the late eighteenth and nineteenth century with the emergence of mutuals (in the European rather than the US sense) and other forms of what Johnston Birchall calls ‘customer-owned’ banks, climaxing with the appearance of Raiffeisen Banks in what was to become Germany (Wolff (1896), Birchall (2013a,2013b). The grinding poverty of Germany in the mid-nineteenth century; the way in which they extracted themselves from that situation over a few decades at low capital cost (and no more banking  technology than paper and pen); and how that model then spread rapidly across Europe, provides important parallels to the current global requirements for affordable finance.

Starting with banks funding agricultural improvements based at the community level, Raiffeisen was able to demonstrate that farmers could collectively self-organise and self-fund huge increases in productivity and profitability purely from their own savings at interest rates, according to Wolff, that were around Adam Smith’s 5%. The natural capital growth of crops provided rapid returns from implementing the low risk farming improvements already well proven in other countries. As local branches prospered, they used surplus funds within a federal structure to set up new branches using revolving start-up funds, and to provide mutual aid when extreme events would otherwise have put a branch under. The same approach was expanded to other businesses throughout Europe and even, as savings/lending mutuals, for funding house purchases.

There were, however, plenty of nineteenth century failures before and after Raiffeisen. There were two consistent themes to these failures. First, third party investors were problematic. Although it may seem a good idea to bring in extra capital in to accelerate growth, their interests are not the same as the customers. Conflicts arise, and the practical experience was that the compromises were not as efficient for the savers and borrowers, as the pure Raiffeisen model. The second issue was that the rewards of the bank employees need to be carefully defined, monitored and enforced. That means bank governance needs to be run on behalf of the customers. In the nineteenth century Raiffeisen banks only the clerk who kept the books in each local branch was (modestly) paid. The rest of the work was done directly by the savers and borrowers. Less successful alternatives to the Raiffeisen Banks allowed more latitude for the personal ambition of employees. The problem is that they will always be more adventurous with clients’ funds (or, for that matter, investors’ funds in investor-owned banks) than the clients themselves, perhaps with the genuine intent of rewarding both. The trouble is they don’t have their capital at risk, which is why they are more adventurous. This has a bearing on current discussions regarding fiduciary duty, and the typically poorer returns on actively managed investments in shares vs. passive tracker funds.

Ultimately it was those banks that kept the simple Raiffeisen self-funded model that became the richest. These banks were simply a means to the ends of the customers, not entities with their own purposes; customers put their own time into running them because they saw this as a means of extending their own businesses’ profitability, and made common cause with other businesses to the same ends.

Today’s descendants of the Raiffeisen banks (the BVR, Volksbanken Raiffeisenbanken) remain important for German business borrowing and savings (although there is a constant debate about drift from their origins), as are customer-owned banks in many other parts of the world. In mainland Europe the movement had assets in 2011 of over €6.9 trillion, deposits of €3.9 trillion and loans of €4.0 trillion, 217 million clients and 56 million members (EACB, 2012). Unsurprisingly, given their SME (small and medium sized enterprises) origins, they remain important sources of total SME loans (e.g. Germany 29%, France 37%, Netherlands 42%, Austria 37%). Their total market share of deposits and credits is similarly impressive (e.g. Germany 19.4/17.5% (plus a further ca. 40% in trustee Sparkassen banks), France 38/28%, Netherlands 39/32%, Austria 37/33%). Credit Unions are also important, although generally serving the needs of those with smaller borrowing requirements. Globally, in 2011, they had assets of over $1.6 trillion in 101 countries (WOCCU, 2012), savings and shares of 1.3 trillion, loans of 1.1 trillion and reserves of 162 billion, serving 200 million members (around four times that of the European cooperative banks, indicating the different customer profiles served). Of these the US had 105 million members, $1.0 trillion assets, $889 billion savings and shares, $605 billion loans and $107 billion reserves.

The BVR was the only part of the German banking system that did not require government aid during the 2007/8 banking crisis. Between 2006–2012 their business lending increased by 27.4%, compared to 16.8% for the trustee savings S-Group banks (these also have a federation structure, with local Sparkassen lending to small and medium sized enterprises, and State (Länder) based Landesbanken, lending to corporates and local government, with the trustees required to ensure the purpose of serving the (local) public interest) and a decline of 14.1% in business lending by investor-owned banks. The BVR’s total assets remained steady at €1 trillion between 2008 and 2012. The trustee banks, like the investor-owned banks, made massive losses, but these didn’t come from the local Sparkassen, whose assets stayed steady at €1.1 trillion between 2008-13, but from the upper tier Landesbanken, which lost €800 billion (asssets of €1.9 trillion in 2008; €1.1 trillion in 2013). As a significant aside, it should be mentioned that the Landesbanken also had close ties as house-banks to the Länder local governments (with whom there might also be close links via the trustees), and served the needs of larger ‘corporate’ business that do not fit well in the local bank model. As a general statement, having local government involved as trustees in local banking can be problematic, because of possible corruption and/or entanglement in politics, even though there is a common interest in seeing local business develop and thrive.

One can observe that in customer-owned and trustee controlled banks alike, surplus funds historically went from the local banks to higher tier reserves and were used to fund further local expansion. More recently, having run out of more Germany to expand into, these were instead used for the same types of banking activities that got the investor-owned banks into such deep trouble. They may have been wiser to have spread their successful local business model to other countries.

Indeed, they could do worse than start expanding in the UK which provides the other extreme of European experience, where the mutual model has been decimated. In the UK the largest mutuals continued to grown in the late twentieth century, consuming their smaller siblings as their managers aggressively pursued growth and diversification. In the process they made themselves increasingly indistinguishable from investor-owned banks, loosing their local identity and branch knowledge. The final step in their growth and diversification process, demutualisation and conversion to limited companies, came when campaigns appeared for the release of accumulated reserves—now a significant part of their net assets—with the supposed goodwill (reputation) to be monetized and sold on following demutualisation. This benefited existing customers and partners: the UK Halifax Building Society (the largest) distributed £20 billion in shares to its members. The conversions also generated massive management fees for external investment banks (such as Lehman) which is why they involved themselves in promoting the demutualisation campaign. But few of the demutualised concerns proved good investments to their buyers, the ultimate losers; the supposed goodwill evaporated without translation into returns. Ex-society members who retained their shares generally find them worth little, and the UK is collectively impoverished by the loss of mutuals. The effective collapse of the UK Cooperative Bank was a similar sorry tale, but it has nothing to do with being a customer-owned bank; rather, just as in Germany over a century before, staff had pursued their own interests rather than of their customers in ways identical to how employees ruined investor-owned banks.

The recent development is micro-finance, of which the Grameen Bank, originating in Bangladesh, is the most famous. Grameen’s interest rate for business micro-loans in Bangladesh is around 20%, and that is not so different from micro-lenders in India. (and see mftransparency.org for other examples) Because of the fixed costs of assessing and making any loan, very small loans of a few dollars will inevitably be more expensive than larger loans. Also the comparison with the cost of borrowing from mutuals and other customer-owned banks are complicated if the borrower is required to have a track record of saving (less often the case for micro-lending). Where micro-lending has become controversial is where the amounts being lent for business development are of the same larger size as those traditionally covered by mutuals for business, yet the interest rates of the micro-lenders appear much larger. Moreover, a significant part of micro-lending is now by investors who are looking for a return on investment. Those involved have changed from the one-time small group of ‘impact investors’ with a more or less clear interest in generating more than financial returns. It is now a general product being sold to mainstream investors, marketed as a means of maintaining high returns rates no longer available through other routes. The concern regarding usury is obvious. MicroRate in 2013 reported returns on ‘micro-finance investment vehicles’ MIVs, of of 57% in 2005-07, declining to 11-17% year on year in 2009-11. Other forms of investment in micro-finance reported returns of 28% during 2009-11. The review Micro-finance and the Illusion of Development provides rapid entry into the world of the critics.

Bearing in mind that these are the rates of return to investors, not the rates being charged to the borrowers (and also that some micro-finance is consumer micro-finance, not business), one nevertheless has to ask how it can be that nineteenth century farmers and small businesses in Europe could find a way of borrowing at 5% with no technology to help reduce costs, yet the costs for their developing world equivalents are so much higher. Santayana comes to mind.

In sum, customer-owned banks arose as highly cost effect means for small and medium sized businesses to collaborate in the management their own finances and the creation of the wealth of nations. Their very reason for their creation was to bend the then necessary trends towards the better management of agriculture and urban businesses, and so allow them to prosper. Where they remain strong they continue to exert downward price pressure on investor-owned banks, to the point that the latter protest vigorously about competition. In this they gained support in IMF reports, that noted that customer-owned banks “can use their low-cost and often abundant capital and the absence of a profit maximization constraint to pursue expansion plans that put competitive pressure on other financial institutions” with the result that “policymakers need to ensure that the competition between different types of banks take place on as level a playing field as possible, avoiding policies that may create artificial advantages in favour of a specific ownership form”. we find our sympathy with Adam Smith rather than the IMF: the point of lending is to support the real economy, those sober people “most likely to make a profitable and advantageous use” of the “capital of the country”.

To the Profound: High Need Innovative Investments

So far we have emphasised business finance relevant to everyday needs in a world where around a billion people exist on no more than the buying power of $1 a day, yet which aims to get to nine billion living well by 2050. However, a good deal of environmental impact comes from wealthy businesses serving wealthy customers, where the issue may not be access to finance but how to bring such investments into line with trend bending sustainable requirements and true value.

This opposite end to sober or mundane finance has traditionally been the domain of bodies like venture capitalists: higher risk, higher reward investments bringing an overall return better than everyday lending, but made up of more spectacular gains and losses. True venture capitalists bring considerable skills and knowledge to an emerging sector to be able to make skilled investments to general benefit, still spread across a portfolio. If they establish a reputation, they may also do this on behalf of other investors. That also applies to investment in environmental and social innovations that address trend bending requirements from early research and development through to mainstream displacement of existing methods.

There are other innovations in investment vehicles, including Green Bonds, Carbon Bonds, Public Private Partnerships and others. Obviously as obscure investment ‘innovations’ were a major part of the scamming that created the 2007/08 banking crisis, such positive initiatives need considerable development and explanation to create trust. This is one of the areas where the Clarity Coalition is active.

The Twist in the Tale: Pension Funds and Insurance Premiums

Some may feel outraged about wicked ‘fat-cat’ capitalists exploiting poverty-trapped farmers in the developing world. There is no shortage of examples as illustrated by the history of the Raiffeisen Banks.

But there is a twist in the tale. Let’s assume that all businesses were profit sharing partnerships with their workers. Those workers still need to save for pensions. It would be extremely unwise to have these entirely tied up in the future success of the business. And people don’t work in the same business all their lives. Yet the experience reported from the nineteenth century onwards was that third party investment was a problem because of conflicts of interest, in customer-owned banks whose customers are both savers and borrowers. So where are these third party investments to go? Having customer owned pension funds that act only in the interest of their customers, and which work through a mutual network federation to provide stability, is part of the solution. Of course that is fairly close to the customer-owned bank model. Tensions would exist whether this is a saver borrower model or a share (equity) based investor-fund manager-investee model. It may in part be resolved by the fiduciary duty of a fund manager to act in the interest of the investor being extended to also cover the general interest in society in seeing investment directed towards the common wealth (fiduciary duty is discussed in the later sections). This is a likely area of innovation, and is another area that we explore as part of the Clarity Coalition.

Finally there is insurance . That may seem very remote from business finance or even pensions. But health and other insurance largely arose from the mutual movement in the nineteenth century, where customers collectively did a rather strange type of saving, which only paid out the savings to those who suddenly had an extreme need. That provided insurance at lower cost and spread the burden, and this was further reduced by investing the insurance premiums. Just as with banks and pensions, investor-owned versions of insurance are also available, but customer-owned and governed insurance exert overall downward pressure on prices. Like pension funds, the premiums have the power, via the investments they support, to help to create a better world. Again, the Clarity Coalition has an interest.

Updated from Future Business, Long Finance, 2014, MMG/SNJ