Companies must make social licence a focus

Investors usually consider factors such as a firm’s balance sheet and growth prospects, often overlooking an increasingly important factor: social licence, says Leon Kamhi

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To illustrate this with a simple example, imagine a factory by a river. The factory has a social obligation to avoid polluting the river with waste because this would be damaging to the people and the businesses within the community that are further downstream. Otherwise, the local government could impose fines on the factory for any resulting short or long-term implications. The reputational fall out for the factory could be catastrophic. Increasingly in today's society, should a company refuse to clean up its act, it loses the support of its customers and, therefore, loses its metaphorical social licence to operate.

This concept of social licence can be applied to most industries, but is particularly poignant amongst banks who, with the tenth anniversary of the financial crisis ringing in our ears, have not yet won back public favour.

How aligned are banks to society's needs?

A number of activities carried out by investment banks are driven by transactions that may not create wealth for the economy. Mergers & acquisitions are an important source of revenues for a bank through significant commission fees, but studies repeatedly show that these deals often destroy value in the newly merged business.

Clearly, it is in the immediate commercial interest of an investment bank for a transaction to go through – as indeed it is for the lawyers and accountants working on it, too. These banks must consider whether they are providing their clients with appropriate advice to ensure that the businesses they manage remain sustainable in the long term.

Turning to trading – what level of trading is required in order to have a liquid market? Probably somewhat less than we currently have. Still, banks commercially benefit every time there is a trade. While so-called prop trading is illegal in the US, there are questions to be raised about the extent to which banks unnecessarily build up stock buffers of instruments and then seek to offload these to clients.

Regulators, too, are probing the investment management sector's activities, demanding more transparency on research costs and other expenses. Historically, these have been written off the value of client provided funds with little explanation to the client of their quantum or rationale. As a result of the regulator's intervention to protect the end investor, many investment houses are now paying for research directly onto their own profit and loss, and we are seeing a subsequent change in their buying behaviour, which in turn is in the interests of the investor beneficiary. The investment industry is under a spotlight and rightly so. It too needs to demonstrate what it is delivering for society.

In terms of retail banking, concern about the impact that high street institutions have had on society is even more immediate and transparent. While a drive towards ownership of property is commendable, banks have done very well out of interest and capital repayments. In allowing mortgages to become easier to obtain over the past 25 years, banks – presumably unintentionally – have contributed to significant inflation in property prices, which has made getting onto the housing ladder almost impossible for many first-time buyers. This is a societal issue that needs to be addressed. Housing supply is certainly one factor that is prohibiting wider home-ownership, but it is not the only one.

Other retail banking examples include the mis-selling of pension protection insurance in the UK and the closure of high street branches. Whilst the latter may make sense from a cost point of view, customer service has not been enhanced – in particular for non-technically minded pensioners who of course represent the investor beneficiary.

Good for society, good for investment returns

In recent years, there have been some headline-grabbing examples – Facebook, Sports Direct, BHS – of companies realising their obligations and addressing a conceptual social licence to operate.

We believe that the companies who address all of their stakeholders - namely society at large - are more likely to be sustainable in the future and deliver better investment returns.

Leon Kamhi, head of responsibility at Hermes Investment Management

Date

16 Nov 2018

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