Banks are the blood line of any economy, having the ability to steer the economy by redirecting capital to where it matters, but also withhold it from other sectors. It is therefore imperative that banks participate in the shift towards a more sustainable development.
Banks’ views on Environmental, Social and Governance (ESG) dimensions has evolved, from being seen simply as philanthropic or Corporate Social Responsibility activities to now becoming central to operations and the business model. Financial institutions are being requested to embed ESG in their overall strategies and risk management frameworks as well as increase their non-financial disclosures. These requests, which were originally being pushed by regulators, are now increasingly becoming market driven, with clients and investors demanding more information on what is being funded and what societal impact it might be having.
This is resulting in mounting expectations being placed on financial institutions, to make public commitments and take actions on the ESG front, thus inevitably putting pressure on Boards to step up their game and actively engage and lead their banks through a number of actions to be adopted.
Boards are being requested to set their bank’s ESG ambitions, positioning their bank anywhere from being a catalyst in the market to meeting the minimum regulatory requirements. By articulating their stance and communicating it top-down in their institutions, Boards will provide the impetus for their workforce to implement the necessary changes, in the various functions, from commercial credit, mortgage lending, retail banking, compliance and risk management, to operations, asset management and human resources.
Banks are increasingly being requested to assess the ESG risk exposure of their portfolios, with emphasis being placed on both physical and transition climate risks. For instance, banks are being asked to understand their exposures to climatic events (e.g. impact of floods on value of collateralized property), whilst also analyzing the risks resulting from the economies moving towards decarbonization.
Boards need to be aware of which industries and/or projects present the highest ESG risks and subsequently decide which industries to potentially exit and which to support in their transition journey and at what pace. For instance, the shift away from fossil fuels will be gradual and will take time and investment by customers.
Despite the challenges that increasing regulation brings about, there are also opportunities which can be reaped. Indeed, boards are best placed to balance ESG related risks with the growing opportunities that environmental brings about. For instance, new green products are being demanded (e.g. green loans), new industries (e.g. renewables) will need financing and ESG-compliant investments will be sought to channel excess liquidity to value-adding projects.
In a recent EY report, ‘How banking boards are elevating sustainable finance and ESG’, the sentiments of US bank directors towards ESG have been highlighted. Amongst others, the report outlines the results of a real-time poll run during a recent roundtable for bank directors, hosted by EY Financial Services Center for Board Matter. 63% of attendees view ESG as a mix of risks and opportunities, whilst only 6% view it as more of a risk. On the other hand, preliminary discussions within the industry indicate that locally ESG is still seen as mostly an additional cost and a risk.
Discussions with a number of local banks have indicated that the one of the main challenges for boards is to keep abreast with the volume of regulation, identifying the myriad of regulations and directives being published, and filtering those that are applicable. Such regulations are mostly principles-based, which on the one hand is understandable and practical, but also leads to a lack of clarity on how to apply them. Another common challenge is the lack of ESG data found at various levels. Most customers still have limited, if any, ESG data, while at a national level climate studies and vulnerability assessments are still being carried out. Therefore, risk models remain difficult to populate with reliable input data. Additionally, risk methodologies are still under development, and standardized approaches still being determined.
However, as one US bank director said, “missed opportunities become risks”. It is therefore necessary that the groundwork is laid by the authorities in terms of a local ESG framework as well as any necessary studies, such as climate studies, so that banks can than take such opportunities and ensure that their ESG efforts are part of a greater national drive. Many banks do not want to jump the gun and push the market too early before any national regulations are set in place.
Whilst 69% of the US roundtable attendees feel they are somewhat prepared to measure the impact of climate change on their business and operations, locally banks seem to be at different stages in their ESG journey. Yet, all recognize the importance of such topics and acknowledge that embedding ESG in their strategy is the way forward.
Boards must therefore juggle the attainment of current results with a longer-term view of the ESG journey. Channeling funds to ensure that the economy becomes greener, inclusive and well governed, whilst minimizing their own risks - possibly the closest win-win situation one could ask for.
