Finance: Research, Policy and Anecdotes

Last week, I participated in a conference on the dynamics of inclusive prosperity in Rotterdam, an interdisciplinary meeting bringing together economists, lawyers, sociologists and philosophers.  Participating in the opening panel session, I was asked to give a short presentation on reinventing finance – a continuous challenge. My main message: an extensive literature has shown the transformative role that a thriving and effective financial system has on economies and societies.  But in order to fulfil this role, the financial system has to continuously transform itself, partly based on the lessons from recent crises but also to confront new social and environmental challenges. In this context, the challenge of green finance has become more and more important.  Green finance, however, is a rather broad topic, encompassing lots of different questions under the broad umbrella of how financial markets react to environmental risks and challenges and how the financial system (and its stakeholders) can contribute to a sustainable environment.  One of my favourite papers in this new strand of the literature is a recent paper by Ralph de Haas and Alex Popov on the relationship between financial structure and industrial pollution.  We know from an expansive literature that banks are more conservative in their funding decisions, going for established industries and firms, while markets are more likely to fund innovative sectors and projects (where the outcome is more uncertain). Ralph and Alex show that this also holds for pollution: banking sector development is associated with faster growth in “dirty” sectors, while capital market development is associated with growth in “clean” sectors. But even within dirty sectors, stock market development (but not credit market development) is associated with cleaner production processes, as these industries also produce more green patents when stock markets expand.

But can depositors also force banks to internalise the environmental costs they impose on society through their lending decisions? This is a question my PhD student Mikael Homanen has addressed in his job market paper Depositors Disciplining Banks: The Impact of Scandals.  Specifically, he shows that  protests against the Dakota Access Pipeline that targeted banks caused significant decreases in deposit growth of banks that funded this pipeline (some of which later withdrew from this project). And the economic effect was also large: Depositors withdrew as much as $8-20 billion from the affected banks. On average, branches lost approximately 2% deposit growth, compared to the annual average of 8%. The depositor reaction was larger in areas closer to the planned pipeline and in areas where households express stronger beliefs in climate change and local readiness for tackling societal challenges.  Mikael then uses global data on bank-specific scandals and shows that this new form of depositor discipline is a much more general phenomenon. Combining scandals on tax evasion (e.g., Panama Papers), corruption (e.g., Libor-rigging scandals), and environmental scandals (e.g., the Carmichael coal mine project in Australia) with a global, quarterly bank-level dataset, he shows that total deposit growth decreases after scandals. The Dakota Access Pipeline was not a one-off!

These are only two examples of papers in this new strand of literature.  There are many important topics to be covered, including very policy relevant ones.  Environmental risks should form part of bank stress tests and in the context of Quantitative Easing the question arises to which extent asset purchases should be titled towards sectors with lower carbon footprint. On the one hand, our planet is too important to ignore the question; on the other hand, questions on central bank independence and mission drift arise. In a nutshell, the area of green finance is a critical issue that requires substantial research but also engagement with other academic disciplines and a multitude of stakeholders.

Overview