More and more, banks are being asked to consider factors outside of traditional risk management.
In some cases, these factors have a bearing on the risks that banks worry about, such as credit or liquidity. But more often than not these factors have only a tenuous tie to core risks and instead reflect the values of various stakeholders. For the last 20 years, we have used the terms environmental, social and governance (ESG) as a catch-all for these additional considerations.
There are many reasons to consider ESG factors.
First, some investors would prefer to direct their investments to specific activities or entities that further goals that reflect their values, such as reducing greenhouse gas (GHG) emissions or promoting diversity (and avoid investments in those that are counter to their values). To this end, you may want to certify that your entity or project has a sufficiently high ESG factor measurement to attract investment related to this factor, thereby gaining access to more capital.
Customers and employees are other stakeholders that take into account ESG factors when choosing with whom to do business and where to work. Customers may want to ensure that their deposits are not used to fund projects that don’t reflect their values. Employees may want to work for a company that promotes diversity and inclusion, both of which are reflected in the social components of ESG scores. Promoting your own ESG scores or related activity might attract more business and talent.
Although many ESG factors have no bearing on traditional sources of risk, there are some that do. The most prominent example is climate, which to some extent is captured in the environmental ESG factors such as GHG emissions. Depending on the nature and location of bank lending activities and operations, emissions might signify exposure to increased regulatory activity on climate risk (such as the implementation of a carbon tax). In other cases a low score on some governance factors might imply a high risk of running afoul of regulators and incurring financial penalties, which in turn might lead to increased credit risk. ESG scores can help a bank avoid some borrowers or simply ensure they are earning a sufficient return. High ESG scores might also reflect high management quality, leading to a statistical association between credit risk and ESG scores, even when no reasonable direct link exists.
Finally, regulation in some jurisdictions requires reporting ESG scores on counterparties, in particular for entities above some size cut-off. Collecting ESG data on your suppliers, customers and other counterparties can be done as part of on-boarding activities and is increasingly becoming part of standard Know Your Customer (KYC) and Know Your Supplier (KYS) practice. This data must be of sufficient quality to support aggregation and fulfil the regulatory standard in question. To fill any remaining data gaps, there are suppliers of ESG data and methods to estimate ESG scores that may be sufficient to satisfy regulations.
To attract investment, customers and talent, you might obtain an assessment on your own bank and improve lagging factors that are important to these stakeholders on an ongoing basis. Risk management activities related to ESG factors could start with ESG data, but it is likely that additional tools or effort will be needed to make the tie to traditional sources of risk. The pertinent regulation will determine what data is required for those activities, though it will likely be some combination of analyst-driven and estimated ESG scores.
The conversation on ESG went from a murmur to deafening in a short amount of time, so much so that taking a first step might seem overwhelming. A prudent, simple first step could be starting the conversation with a trusted advisor and key stakeholders at your bank to settle on your goals and needs, immediate or anticipated. The world of ESG is multi-faceted and so may seem complicated, but can be made simpler once you determine why it matters to your organization.
