Supply Chain Risks and Challenges in Financial Intermediation

Global supply chains are the fundamental basis of economic development worldwide. Through a complex and organized structure, they aim to boost the production and trade of productive activities. In the member countries of the Organization for Economic Co-operation and Development (OECD), the logistics sector represents 10% of GDP on average. According to the Economic Commission for Latin America and the Caribbean (ECLAC), the logistics sector directly contributes 7.5% to GDP and generates about 6.4% of direct formal and informal employment in Latin America.

The modern economy is organized into supply chains, which generates value in productive activities. This fosters a business ecosystem among different actors, including providers, manufacturers, transporters, distributors, wholesalers, and the final customer. A strong relationship between production and employment is generated that has as its objective the global supply of goods and services. Supply chains also represent a major challenge in terms of employment, human rights violations, child and forced labor, human trafficking, greenhouse gases, and a range of environmental impacts, particularly important in an economy of scale such as Latin America.

LATAM region

In Latin America and the Caribbean, an estimated 1.2 million persons are subject to forced labor, according to data from the International Labour Organization (ILO). It is also estimated that the value of child labor linked to direct and indirect goods and services exports for LAC still amounts to 22%. The share of child labor in exports reaches 40% in the region. In South America, it is estimated that these exports represent 15.4% of total employment.

On the other hand, Latin America and the Caribbean is responsible for a significant proportion of net greenhouse gas emissions (45% of the total) related to agriculture, change in land use, and forestry combined, versus a global average of 14%. Similarly, 80% of international trade goes through global supply chains and, though emissions from those supply chains are low in terms of global emissions, they are very dependent on carbon-based sectors and based on the exports of fossil fuels.

Environmental and Social Effects of Financial Intermediation Operations

There are a variety of cases of environmental and social impacts in these operations linked not only to those exposed to them, but also to irreversible impacts such as the contamination of water and soil, massive deforestation, forced resettlements, impacts on livelihoods, and adequate and just compensation. The negative effects impact both populations and the environment.

In this sense, development banks are necessary to promote investment in the public and private sectors, and even to address the financial crisis caused by COVID-19, since it represents a growth opportunity for countries in the process of economic and social development. The financial risks of providing credit through financial intermediation in operations becomes even more complex precisely because of the intervention of intermediaries, regarding which there is a lack of information about subprojects and final borrowers, as well as follow-up and monitoring in the execution of these investments. Due diligence, restrictions regarding projects that sub-borrowers can finance, and supervision of the sub-projects are key to eliminating risks and addressing the impacts that could arise.

Global Risk Management Initiatives

Global initiatives such as the Early Warning System are working with the banking sector. That initiative is promoting better monitoring and transparency of operations with financial intermediation, which allows for identifying and managing the negative impacts caused by the execution of these investments. The Artificial Intelligence software for sustainable investment, MALENA, allows for collecting significant information on social and environmental data in order to generate information for borrowers, regulators, and environmental, social, and governance analysts.

Environmental and Social Management Systems

Focusing on due diligence in the preparation of a loan with financial intermediaries and understanding the sub-project, sector, and location are fundamental, particularly for investments that pose high and substantial environmental and social risks. During execution of the loan, it is critical to have selection and eligibility criteria. Toward this end, establishing a solid and high-level Environmental and Social Management System (ESMS) or its equivalent for the banking sector, an Administrative System for Environmental and Social Risks (ESRA), will enable the borrower to establish the depth and scope necessary to manage the environmental and social risks and impacts in its investment portfolio.

ESMS, ESRA

The ESMS or ESRA thus will have to analyze which of the potential problems the borrower could face, such as:

• Lack of visibility of the primary supply chains
• Capacity to incorporate effective actions that are proportional to the level of risk
• Demonstrating the risks
• Providing information on labor accidents and on human and physical resources needed for the handling of the risks, among others.

In conclusion, exposure to these types of risks in these types of financings is unavoidable, and it is necessary that the banking sector, a fundamental actor for development, is able to guarantee that financial intermediation projects meet environmental and social requirements. In this context, satisfactory application of environmental and social standards and, in the case of operations financed by the IDB, the Environmental and Social Policy Framework, will allow for effective management of the risks in all stages of the life cycle of a sub-project, based on a hierarchy of mitigation, and will in turn foster access to justice in environmental and social matters.

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