Founded in 2016, Ceteris Paribus is A student-led economics and finance publication at Davidson College.

Social Impact Bonds

by Spencer Patten

 (Image via Goldman Sachs)

(Image via Goldman Sachs)

 

When you think of Wall Street, what values come to mind? Is it hard work and social utility or greed and the desire for money? In the past few years we have seen the financial sector demonized by stories of greed and mistrust. Whether it was the financial crisis of 2008, the film “Wolf of Wall Street”, or the recent unethical behavior of Wells Fargo, our generation has grown up seeing the worst the financial sector has to offer. But is there hope to reclaim Wall Street as a means of social good?

One tool that could help is the Social Impact Bond. Although there in the name, a SIB is not a securitized bond. It can not be bought, sold or traded, and therefore is categorized as more of a equity investment or contract. This contract is between the public and private sector in which private investors give money to an intermediary group which then lends money out to certain non-profit organizations in order to achieve some sort of social good.

Say the United States government wants to increase graduation rates in Detroit. They may have many reasons for doing so whether it be the belief that everyone should graduate high school or that the lack of skilled and educated workers is hurting the economy. Either way, the federal government cannot just throw money at the school districts in Detroit because that will not necessarily solve the problem. Instead they can issue a Social Impact Bond with an intermediary group, say Goldman Sachs, to increase graduation rates. Goldman Sachs would then raise money through investors for this project. Once they raise the predicted necessary money for the project they distribute this cash to one or many Non-profit organizations. The assumption is that these NGOs are more qualified and specialized in solving the particular problem at hand but lack funding to adequately solve the entire issue. With the added funding from Goldman Sachs through the SIB, these nonprofits are able to have direct, meaningful effects on increasing the graduation rates in Detroit from a number of different approaches. If this bond has a maturity date of four years, then Goldman Sachs has four years to see the graduation rates in Detroit rise to the desired level. So how does Goldman Sachs make money on the bond? Once the desired social good is achieved, and graduation rates are increased then the Government will pay out to Goldman Sachs plus a premium. The caveat is that if the graduation rates do not increase in the time period, Goldman Sachs does not get paid by the Government and would lose money.

This is where the Social Impact Bond is useful. It allows for the government to pass on their risk to Goldman Sachs and will not waste taxpayers’ money on programs if the graduation rates do not increase. At the same time, if it these graduation rates increase, then the cost of having less skilled workers in Detroit is avoided and the Government can pay that difference to Goldman Sachs, while still retaining lower costs in the future. It allows for specialization of non-profit work and incentivizes Wall Street to invest in human capital and social utility.

There are many types of social impact bonds, including Development Impact Bonds. These DIBs follow the same framework but target developing countries to increase development on many different fronts.

Most recently states such as Massachusetts and New York have used SIBs to reduce recidivism in inmates. Around the world, different governments have used SIBs and DIBs to increase development, as well as to reduce drug use, homelessness, and healthcare costs.

I hope to see Social Impact Bonds being used to incentivize the private sector to do good in their communities and increase social utility on all fronts. I particularly have an interest in using SIBs to increase educational opportunities and achievement for students across the United States.  

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