transformation, payment services, risk management and information processing, and monitoring of borrowers. In this sense, financial intermediaries act not only as agents who monitor and screen on behalf of the savers and investor. They are innovative themselves by offering products that mainly aim to cover risks, which is impossible for individual savers (Scholtens, 2006). King and Levine (1993) conclude, by providing statistical evidence, that there is a strong correlation between financial and economic development und thus supporting Schumpeter’s (1934) arguments of finannce’s role in the process of ‘creative destruction’. Although their findings focus mainly on the

link leading into the direction of positive development, the recent global economic trends serve as evidence that this relationship also holds true the other way round (Allen & Gale, 2008). Therefore, it is reasonable to state that finance directs our economy. By doing so, financial institutions shoulder huge responsibilities and it is worth questioning to what extent they can direct the economic development towards a more socially and environmentally sensible manner, and thus more sustainable. Figure 1 shows how finance and sustainable development can relate to each other. The possible transmission channels will be examined in the following section. As this figure from Scholtens (2006) has been slightly adapted by adding the requirement

for an effective implementation of CSR ² into the operating processes at the firm level of the finance intermediaries itself (top arrow), a further explanation will be provided in section four.

² CSR will be subsequently referred to as ‘the commitment of business to contribute to sustainable economic development, working with employees, their families, the local community and society at large to improve their

quality of life’ (WBCSD, 2004).

- 2 -

The possible link between finance and sustainable development

Most of the academic literature has identified three possible channels through which finance can help to achieve sustainable economic development at the macro-level: Kuznets curve, socially responsible investment, and stakeholder power. The environmental Kuznets curve describes the inverse U-shaped relationship between the economic growth (per capita GDP) and per capita environmental polution (Grossman and Krueger, 1995). As this trend can hardly be a concern of individuals, I will focus on the latter two transmission channels. Socially responsible investment (SRI) now accounts for $1 out of every $8 under professional management in the US (SIF, 2010). SRI funds are investments that are restricted by either simple bans on alcohol or tobacco companies or rules that guide investments by firms’ received ratings for their environmental and social performance from agencies such as Innovest. A rather sophisticated SRI fund allocates its investments into corporations by sector similar to the way that conventional funds do, but allocations within the sectors are guided not only by financial characteristics but also by non-financial characteristics, namely social and environmental concerns (Heal, 2005). Several empirical studies tried to compare the financial performance of SRI funds in comparison to conventional funds. While Scholtens’ (2006) literature review of these studies suggests that there is no significant difference between both investment types, other authors do find evidence that SRI outperform conventional funds. Heal (2005) concludes that, despite traditional theory suggesting that restrictions of portfolio choices lead to underperformance, there is some but not yet robust enough evidence that SRIs do have the potential to generally outperform competitor funds. According to him, CSR profiles of firms provide additional information, in contrast to the assumptions of the Capital Asset Pricing Model, most widely used in finance. CSR policies give an additional dimension of information to analysts and thus investment risks due to potential concerns from society can be better predicted. This fact helps to explain the correlation between superior environmental and economic performance. One of the most striking finding was provided by Kempf and Osthoff (2007). By following the simple trading strategy of buying stocks with high SRI rating and selling stocks with low SRI ratings, they obtained abnormal higher returns. As not much research has been conducted on the underlying reasons, promising answers are still to come as many authors expect the rapid growth of SRI funds to be continued, especially due to the growing adaption of institutional investors, such as pension funds and insurance companies (Sparkes & Cowton, 2004).

Another important channel through which financial institutions can help to achieve sustainable development is their power, meaning the bank’s usage of their influence through being either lender or shareholder of corporations. Although Johnson (2003) argues that most

- 3 -

of the SRI funds’ share size is yet too small to have significant impacts, others argue that SRIs can affect directions of business strategies substantially. SRI funds can raise ethical issues and allow dialogue with management in a “non-formal and non-confrontational environment” (Scholtens, 2006, p. 25). A more promising way of banks’ potential influence on the behaviour of firms can be identified in their direct provision of bank credits. As direct bank lending is significantly larger than stock market capitalization in the Western economies, the financial institutions can have huge impacts through exercising power due to their position as lenders, as the following two examples show. Firstly, by providing entrepreneurial finance in the first stages of firms, banks can influence their strategic decisions and therefore, attitudes related to CSR (Scholtens, 2006). Secondly, banks can comply with a code of conduct that excludes the possibilities to invest in environmentally unfriendly and socially inresponsible projects in emerging countries. The Equator Principles serve as the major framework for the financial industry, which addresses these issues. Signatories, now more than 70 financial institutions, commit to provide large-scale project financing only to borrowers who comply with certain social and environmental policies (Hoepner & Wilson, 2010). Although some NGOs criticized the subsequent implementation of these rules, the framework can be seen as a successful effort of the industry towards a more sustainable economic development. A global stakeholder involved consultation process, conducted by HSBC, also showed that sustainable lending and finance are stakeholders’s primary concerns, higher ranked than stafftreatment or other environmental issues (HSBC, 2008). Creating shared value in the banking sector

There are several reasons why the profession of bankers can be seen as distinct from many other professions. In a very emotional appeal demanding more ethical behaviour from Swiss bankers, Rossier (2003) stated that apart from the attribute that bankers trade third-party money, representing others’ securities and well being, their profession has been held in contempt since medieval times because of usury laws and still remaining image problems. For this reason, reputation and trust is a crucial issue in the banking industry. Trust is a functional prerequisite to the bankers’ operations because financial contracts are characterised by information asymmetry and uncertainty. An “erosion of trust” (Hoepner & Wilson, 2010, p. 19), as experienced especially during the shade of the current financial crisis, has widespread damaging consequences not only to the industry but to the macro-economy. Decker and Sale (2009) state that reputation is build on the trust that is established together with all stakeholders and therefore represents an asset that directly affects the success of financial service firms. In this sense, it is crucial to both the banks’ sustainability and to the

- 4 -