Sustainability – The Way Forward for Banks and Regulators

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The Effect of Sustainability in Banks – Management and Risk Perspective

Due to new research, recent events, and increased attention from the media, awareness of various sustainability topics has increased. Recent data from the World Economic Forum shows that most adults in the world are aware of the United Nations (UN) Sustainability Development Goals (SDGs) published in 2015. There is a total of 17 goals, ranging from ending poverty and hunger, education, gender equality, and tackling climate change. The United Nations hopes that the 2015 SDGs can be achieved by 2030.

Sustainability is concerned with more than just the depletion of natural resources. It seeks to achieve non-destructive economic growth that can be enjoyed by future generations. This call is not easy to answer, and it does not have a unique solution. Not only do people define it differently, but regulatory bodies also face the challenge of clearly stating what sustainable growth means and what the relevant actions are. Nevertheless, the vast majority can agree that for the past decades, economic growth has had a lasting negative impact on poverty, inequality, instability in regions, and our natural resources.

The Challenges in achieving Sustainable Growth

The achievement of sustainability goals requires cross-border and cross-industry cooperation, hence posing a major challenge to market players. However, there are industries whose contributions have larger and more significant impact. Banks, as providers of financial resources, want and need to be part of this change. It is because of their important role in providing the means to growth, that a series of guidelines, suggestions, and market best-practices have been developed by different institutions to guide banks in the implementation of sustainability criteria. Nevertheless, the implementation of these criteria within banks comes at Nevertheless, the implementation of these criteria within banks comes at a cost and will have an impact on profitability.

In 2019, the European Parliament published Regulation (EU) 2019/2088. In a nutshell, this regulation aims to establish “harmonised rules for financial market participants and financial advisers on transparency with regard to the integration of sustainability risks and the consideration of adverse sustainability impacts in their processes and the provision of sustainability‐related information with respect to financial products.”[1] The most significant effect of this regulation is the transparency requirements set on financial market participants, such as, but not limited to, transparency on their sustainability risk policies, the impact of adverse sustainability outcomes on their firm, how they consider these risks in their investment decisions, the sustainability impact of financial products, how environmental and / or social characteristics are fulfilled by the financial products.

This regulation has been accompanied by publications from other regulatory bodies. Relevant guides and opinions on considerations and expectations regarding sustainability goals and supervisory mechanisms have been published. For instance, the German Regulator has published the Information sheet on dealing with sustainability risks (Merkblatt zum Umgang mit Nachhaltigkeitsrisiken). Similar publications have been made by the Bank of England and other regulatory bodies. In July 2020, the U.S. Securities and Exchange Commission’s (SEC) Investor-as-Owner Committee concluded that the SEC must address the Environmental, Social or Governance (ESG) risk disclosures. They suggested to provide a “framework to disclose material, decision-useful, comparable and consistent [ESG] information.”

Despite banks being aware of these issues, Sabine Lautenschläger remarks that banks approach them from a Corporate Social Responsibility (CSR) perspective, instead of viewing them from a Risk Management perspective. This is partly due to the absence of clear guidance from regulators. Furthermore, there are few examples of how financial firms could implement the sustainability goals. For instance, there is a growing appetite from retail investors to look for ESG-compliant products, yet it is unclear for financial institutions what the risk implications are when offering these new products to clients. Institutions will have to deal with changes in their back-, middle-, and front-office processes. The focus, or lack thereof, of sustainability criteria in financial institutions, will give senior managers one more challenge to tackle, namely, where and how is the institution assuming new, not yet before known, risks.

The Overarching Impact on Bank Management and Risk Management

Regulators expect Banks to include sustainability in the equation when defining their strategy, mission, processes, and reporting standards. However, how can banks correctly quantify and analyse the impact of sustainability in the above-mentioned categories? Certainly, there is no just one specific department, process, or reporting that will be affected. It will rather be a coordinated effort across the entire organization to ensure that the goals are met, and the adequate governance and tools are implemented.

Sustainability and the risks associated are in many cases difficult to quantify. One can quantify the economic loss of an oil spillage. However, there is more uncertainty in estimating the reputational damage and loss of future business. Thus, a holistic approach is critical. The implementation of processes and models to manage and quantify sustainability risks in an organization must consider the entire lifecycle of a financial product / business relationship between bank and client. For example, while defining the Corporate Strategy it must be analyzed, what sort of client relationships will be accepted. Should a client with a carbon footprint above a certain threshold be onboarded? How should sustainability risk exposures be tracked throughout the bank-client relationship? What events could trigger the exiting of a business relationship or re-negotiation of financing contracts?

The above questions will occupy the attention of various departments, leading to an analysis of current bank processes and decisions about which processes require changes. The following questions need to be at the center of bank management to define the strategy for the coming years and designate priorities for implementation projects in change-the-bank initiatives.

• What is a bank’s sustainability vision and strategy to achieve sustainability goals?
  • What are market expectations with respect to businesses pursuing sustainability goals
  • How will resources be allocated to ensure that, despite a heavier weight in green-financing, capital requirements are met?
• What is a bank’s approach to managing ESG-related client risks?
  • What key indicators will be used to track business relationships and develop early warning reports for Senior Management?
  • What are the ESG requirements regarding new clients?
  • When sustainability metrics could lead to a termination of a client relationship?
• How will ESG-related risks and exposures be quantified, managed, and monitored?
  • How should ESG risk factor projections be gathered?
  • How are ESG risk factors incorporated into a bank’s models, e.g., credit models?
  • How should ESG risks be accounted for in credit ratings?
• How do risk departments approach risks related to ESG characteristics?

Besides these questions, banks must also look at Business Continuity Management (BCM) scenarios. For example, in the case of catastrophes, there must be a clear BCM process that ensures the adverse impact, both reputational and financial, is minimized. Not only is this important for society, but from a shareholder perspective, the impact on reputation must be minimized. This is ensured by having robust plans in case the ESG requirements agreed upon are not met.

In addition, banks must consider if there are any regulatory benefits by having a strong footprint in the Sustainability market. As this is still a relatively new development, being the first mover might give advantages with positive future payoffs, both reputational and financial.

ESG Criteria and Limit Management

From the questions listed above suggest that the lack of ESG criteria in the decision analysis will have tangible impacts on a bank’s portfolios. Therefore, the company must continuously track their KPIs to have an exposure limit management that aligns with their ESG-Strategy.

In most cases, banks should be able to map ESG criteria to a specific adverse impact. For example, investing into an ocean-front real estate development may not be worth it when the increasing likelihood of flooding / hurricanes is not accounted for. These extra expenses may increase the risk of default. Having credit lines with such companies may have an adverse impact. Therefore, the lender must include these factors, coming from the non-sustainable nature of the business, into its exposure limit management. For instance, by having an overview of how a client is using its credit line (i.e., what proportions are going to what project), even for complex corporate structures, where a client might be active in different markets, banks can effectively manage how exposed they are to ESG risks. Further data drilldowns may provide a view on which ESG-friendly initiatives a client has taken, in order to free-up limit capacity. Based on historical values and environmental risks, a bank can manage limits more efficiently based on the industries their clients are active in (e.g., renewable vs. non-renewable energy, oil & gas, among others).

Another way of managing limits is to include covenants in loan agreements. For example, a conglomerate who produces motor vehicles worldwide can be incentivized, through covenants, to invest in projects that align with sustainability goals (e.g., electric vehicles). A consolidated view of the projects where the money is being invested can allow banks to tackle exposure limit management from an ESG perspective and uncover more business opportunities by offering better loan conditions or by bringing together ESG investors.

Given that this is still new terrain for both banks and regulators, there could be cooperation between financial institutions and regulators to expedite the implementation of such projects. Regulators and the industry leaders could co-develop a framework for ESG risk disclosure and quantification. It would reduce the effort that investors need to collect all relevant and quality information, reduce effort for constructing baseline risk metrics and allow focusing on granular modelling of more material exposures.

A sustainable future powered by the cooperation between Regulators, Banks and Technology.

Regulators have already provided financial institutions with some guidance, and a high-level framework that can be applied to revise ESG strategies and associated risks. The fact is market participants cannot wait for perfect definitions and crystal-clear guidelines and regulations to start acting. The Covid-19 pandemic serves as an example that the industry needs to be ready for adverse conditions, and as such, there is no time to wait but measures must be taken immediately.

The detailing of sustainability-related regulation will increase in the coming years, not only for banks but also for public and large companies. This gives room for cooperation between banks and corporates. The earlier actions are taken, the earlier the efficiency gains will be realized. A successful implementation of these new measures will have three key drivers:

• Mindset – openness to new tools, technologies, and ways of working.
• Clarity – clear regulatory expectations with respect to disclosures and risk management.
• Partnership – the correct partner must be chosen to implement the correct tools and technologies. State-of-the-art technologies that are flexible enough to consider all the challenges need to be accompanied by an implementation partner that has sustainability among its priorities.

IBM has for decades had sustainability in its priorities. Already in 1971, the company published its first corporate environmental policy. In the following years, IBM has been able to certify itself and received several awards and prizes. Furthermore, the firm is committed to help companies across industries to achieve the desired sustainability results. The company’s compromise not only lies in having the relevant sustainability policies, but also in ensuring that, with the technology and knowledge at hand, the best tools are developed to support customers around the globe. These tools and technologies cover the entire lifecycle of a business relationship or transaction.

Among the suite offered by IBM, there are several technologies that can support departments in assessing sustainability risks throughout the entire lifecycle of a business relationship. For instance, Know Your Customer (KYC) tools can be expanded to include sustainability criteria while onboarding and assessing the risk of a client. Data analytics can help institutions quantify their exposure to climate risk as well as the potential impact of this risk on their portfolios. In addition, these data can be used for disclosure to investors who want to ensure that they have a carbon-efficient portfolio. Last but not least, the calculated risk parameters can be used for various departments; some will use them to track a business relationship and develop early warning reports, while others may use them to calculate the impact on capital requirement calculations and the enhancement of risk models.

IBM Climanomics™ offers the perfect technology to integrate ESG related risks into risk models and quantify the effect of these risks on portfolios. The quantification of climate related risks follows the Taskforce on Climate-Related Financial Disclosures (TCFD) framework. Furthermore, it can offer multiple views, such as financial impact, scenario analyses, and insights both on an asset and portfolio level. It highlights a.o. what the greatest risks are, where they are, and when the greatest risks are predicted to occur. IBM Climanomics™ can quantify the exposure to carbon and climate risk in a portfolio and give insights as to when this exposure is at its peak.

In conclusion, the above-mentioned considerations are of paramount importance to define the near-future strategy for banks. As originally thought, the impact is not only the potential reputational loss of not being ESG compliant. The reality is that sustainability impacts Banks’ strategies, management, and risk management. The challenge is too complex and important to be solved alone. IBM brings the perfect competences, tools and technologies to the table. We have shown to care about sustainability, putting it among our top priorities. Together with our technology and mindset we can work together for a better future.

Authors

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References

[1] Article 1, Regulation (EU) 2019/2088 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 27 November 2019 on sustainability‐related disclosures in the financial services sector. Link to Regulation: https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019R2088&from=EN

Oliver Schutzmann, “ESG stocks prove their value during Covid-19 crisis,” IR Magazine (Apr. 3, 2020); UBS Asset Management – Global, “How has COVID-19 impacted ESG investing?” https://www.ubs.com/global/en/asset-management/insights/panorama/mid-year/2020/covid-19-impacted-esg-investing.html