Let's Use Financial Engineering for Good, with a New Structured Product
The conventional response to an economic crisis – such as the one caused by the current pandemic – involves increasing liquidity by boosting credit. But this creates risks that cannot be ignored.
These risks include not only the most obvious, such as the possibility of excessive financial sector exposure, but others that are less obvious. Such as, for example, that in the process of stimulating the economy, fundamental principles that go beyond financial matters are forgotten, including the fight against climate change.
To resolve this tension, a possible solution is the use of blended finance products, including one that we have created for banks in Latin America and the Caribbean. The product is, in financial-speak, a subordinate zero coupon structure that strengthens the borrower's capital position.
For non-experts, the idea is that financial institutions receive funds in the least onerous conditions possible, and at the same time they can make commitments on climate change. Hence the design.
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The product has two fundamental characteristics: the first is that it can be subordinate – that is, it may have a lower collection priority for the holder than those contracted with other creditors. This debt is similar to capital so it is computed, according to each country's regulation, as capital in the borrower's accounts.
The second feature is tied to the zero coupon. This means that the financial institution that has contracted this product does not pay any interest or return any cash during the life of the loan. At maturity, principal and interest are paid on time, but not before.
There's more. And here we enter the part that includes significant innovation related to a series of objectives that the borrower, the financial institution, accepts when signing the contract.
These objectives, which are presented not as covenants or mandatory conditions, but as incentives, refer specifically to the principles we want to enact: for example, that the financial institution joins the Task Force on Climate-Related Financial Disclosures (TCFD) and follows the TCFD recommendations on how to analyze and report exposure to financial risks associated with climate change. Another concrete milestone is that the percentage of the borrower's total loan portfolio that is earmarked for deals that generate positive environmental impacts, such as the reduction of greenhouse gas emissions, is increased.
The borrower has an interest in including these objectives in the contract, because there is no penalty for non-compliance – since they're not mandatory – so it has flexibility; but, if it meets the objectives, this results in a reduction of the interest payable: that is, hard cash savings.
We have created this product, for the first time in IDB Invest's history, with the aim of offering it to the financial sector, including not only banks but also credit institutions, including – possibly – fund management companies. With this product we want to encourage changes at the corporate level in the financial sector institutions to achieve desirable climate results; that is, to encourage policies and processes to work for and finance a low-carbon economy that is resilient to climate change.
We aim for institutional change to increase the scope of our work, with measurable and positive impact results for the climate, seeking portfolio growth that is several times greater than the loan amount. The first related transaction has been closed with Davivienda, one of the leading banks in Colombia. But there's potential for many different approaches.
The expression “financial engineering” is often used as a criticism, to refer to complex and innovative products in the financial world that some use to hide losses or pay less tax. We believe that, with this product, we are using financial engineering, finally, for the benefit of all.