The seemingly inexorable rise of ESG factors in the investment landscape took on a new impetus this week, in particular for the banking sector. Banks will no longer be able to just pay lip service to ESG concerns – ESG factors must become a central strategic consideration in the boardroom as ESG factors become key elements of how banks are perceived, valued and invested in.
Bank stakeholders are becoming increasingly aware of ESG issues, and are demanding improved ESG management. This is illustrated by investors’ rapid integration of ESG factors into their asset allocation decisions.
So it was very timely when Moody’s Investor Services, the credit rating agency, issued a report entitled, ‘The impact of environmental, social and governance risks on bank ratings’. The comprehensive and detailed report was intended as a guide to the ratings agency’s thinking on ESG issues, and how these issues influence its measurement of a bank’s risk-weighting and credit score.
This approach is not new, but the report offers a comprehensive explanation of how ESG factors can influence banks’ ratings, and therefore their financial performance. Bank boardrooms are awake to this new catalogue of risk factors, but sometimes there can be a mismatch between growing ESG demands and banks’ responses to them.
Governance: The main ESG risk for banks
In addition to examining and explaining how it rates environmental risk, the Moody’s report also does an excellent job at addressing the ‘G’ element of ESG. ‘Governance is the main ESG risk for banks,’ it points out.
Moody’s is very clear on governance risks: ‘Governance quality is particularly important for banks because they operate with higher leverage and are generally more confidence-sensitive than corporates, particularly regarding their funding arrangements. The consequences of a governance breach can go beyond the immediate impact, such as a financial penalty or asset quality deterioration. In some cases, there can also be reputational damage leading to franchise erosion, resulting in a loss of business, or customers withdrawing funds.’
And yet the public disclosure, annual report and media presence of many banks, large and small, often treat the governance element of ESG almost as an afterthought. Environmental issues take center stage, but social and governance concerns tend to be secondary – with the result that governance failings continue in the sector, often driven by their businesses’ impact on society.
And the risks of this two-tier approach to ESG are high: reputational damage because of poor governance affects banks’ profitability and liquidity. The loss of customers disillusioned by governance failings affects a bank’s business volumes and therefore its earnings capacity. Customers may also withdraw their funds, and the banks’ issuances may attract less market interest, as investors increasingly integrate ESG considerations into their investment decisions.
The difference is that the scrutiny on their efforts in this regard is rising every day. If investors feel a bank is short-changing them on ESG, they will sell their shares. If Moody’s perceives a sub-standard execution of ESG safeguards, it will downgrade, resulting in a higher cost of capital and diminished returns. A vicious cycle could easily be triggered by ESG concerns alone.
In parallel to these actions by ratings agencies, governments, policy-makers and regulators are also driving change in the banking industry to take ESG into account, and the latest example of this trend came out of the UK this week.
Launching its Green Finance Strategy, the UK government revealed that it will be mandatory for all listed companies and large asset owners to disclose the environmental impact of their activities by 2022. This move is in line with the Task Force on Climate-related Financial Disclosures (TCFD), a multilateral body that exists to bring climate action to the forefront of the business and economic agenda.
The UK is an early adopter of the aims of the TCFD and, in 30 months’ time, all listed firms will have to be fully transparent about the climate impact of their activities. The UK government strategy is ‘to align private sector financial flows with clean, environmentally sustainable and resilient growth, supported by government action.’
The move was welcomed by the UK’s banking and financial services industry. The ‘E’ in ESG is now firmly embedded in government policy, regulations and private and public sector strategy.
Add to this the actions and approach of Moody’s and the other ratings agencies, and it is clear that business in general and the banking sector in particular are going to be at the forefront of ESG adoption, and fundamental strategic change is inevitable.
The rapid and large-scale adoption of ESG criteria by institutional investors is being matched by the actions of ratings agencies, governments and regulators. For listed companies and investors, this is a seismic shift.
For banks, as Moody’s makes clear, the issue demands to be front and center of their strategic thinking. Ignoring the change is not an option. In the UK, from 2022, how banks respond to these demands will be the subject of full disclosure.
Wherever they are based, and wherever they do business, banks are about to undergo a major transformation in what they report and how. The big question is: who will adapt and thrive – and who will not and perish?
Oliver Schutzmann is CEO of Iridium Advisors