Leverage, Engagement, and Welfare in Decentralised Financial Markets

Yang Guo talks to Tom Gosling about her paper Leverage, Engagement and Welfare in Decentralised Financial Markets. The paper considers so-called “mandated funds” (sometimes called impact funds) which have a specific objective to address social goods such as the green transition. They discuss the free-riding problem that causes firms and funds to underinvest in projects that would enhance social welfare, and which challenges the ability of such funds to raise finance. Why should an investor that only cares about returns invest in such a fund?

Yang explains the role of households who invest in cash deposits at banks rather than the stock market. The low interest rate earned on these deposits enables low-cost finance for the mandated funds to enhance leverage and make the returns viable for profit-seeking investors. This enables the funds to attract capital from return-focused investors not just those concerned about social welfare. The sector can then grow, increasing the share of firm equity held by the funds, leading to more firms transitioning to green, despite investors being entirely profit-motivated. The paper demonstrates the importance of market structures - not just fund types and mandates - for driving investment to the green transition.