ESG isn’t just PR — it’s the new frontier in risk management

Today, there is much discussion about environmental, social and governance (ESG) issues and their societal implications for 2021 and beyond. The past year has shown how quickly an environmental event can have implications for the entire economy. The focus on ESG challenges bank executives to identify how environmental, social and governance matters will be transmitted through the economy and affect a bank’s portfolio of risks.

Bankers have been working for years to fine-tune their risk management frameworks. While ESG issues may represent macroeconomic concerns, they can have very real microeconomic impacts. ESG risks will have an impact on the traditional credit, market, liquidity, operational, legal and reputational risks that bankers have developed risk frameworks to manage.

The focus for bank executives should be on ESG’s relevance to risk management and financial soundness. This is the prism through which bank regulators and supervisors will assess banks’ efforts in this area. Put simply, ESG is a credit, reputational and supervisory risk issue. When a financial institution lends money and takes on credit risk relating to environmentally or socially sensitive assets and/or business practices, the underlying assumptions regarding creditworthiness and collectability can turn out to be fragile and can be upended very quickly. And even under the best circumstances, other lenders’ declining appetites for financing certain types of activities can create meaningful rollover risk.

Enumerating ESG Risks

The price of assets supporting repayment or collateral securing loans can decline rapidly, and well before the loans mature. For example, mortgages secured by collateral in hurricane zones may become riskier if climate change causes an increase in the number or severity of storms.

In addition, ESG transition risks may result in cash flow disruptions that impede the ability to service debt. For example, an accelerated transition to green energy or a significant price change on carbon emissions could result in cash flow shocks to the oil-and-gas sector from the combined effect of greater costs and reduced demand.

In the consumer portfolio, increases in flood insurance may interfere with borrowers’ ability to repay existing mortgage debt. The average cost of flood insurance policies increased 11.3% in 2020, and the Federal Emergency Management Administration’s Flood 2.0 changes may result in additional increases of up to 25% per year for certain higher-risk properties.

Governments may respond to public pressure by limiting industrial activities that form the basis for loan or investment repayment. We see this pressure in the coal industry, where there are more than 450 environmental and community lobbying groups pressing for the end of coal finance. Other industries previously targeted by regulators or advocates include private prisons, abortion clinics, factory farms, gun manufacturers and retailers, money services businesses, foreign correspondent banks and oil-and-gas companies.

Lobbying, regulatory and public pressure activities aimed at inducing banks to sever their financial services access to “disfavored (but not unlawful) sectors of the economy” were among the stated reasons for the promulgation of the “Fair Access to Financial Services” rule by the Office of the Comptroller of the Currency during former President Trump’s term. (That rule has yet to, and may never, take effect under the Biden administration.)

Laying the Operational and Regulatory Groundwork

Regulating ESG has risen to the tops of national and international agendas. In January 2021, the Federal Reserve formed a Supervision Climate Committee and Financial Stability Climate Committee to build regulatory knowledge of the implications of climate change for financial institutions and stability. The Office of the Comptroller of the Currency has noted that national banks and federal savings associations need to understand, monitor and mitigate the risks of climate change. The Securities and Exchange Commission has requested public input on ESG disclosures, and the World Economic Forum has recommended a global ESG disclosure regime.

Although some might believe that ESG is mainly a public relations issue, these recent regulatory statements and actions show ESG is not limited to public relations. We believe that focusing on ESG fundamentals from the perspective of credit risk and safety and soundness is the best way to safeguard one’s institution in an environment of rapid change.

Questions that need to be asked include:

  • Should I continue to lend to clients in these industries? If so, under what terms and conditions?
  • Should my lending be confined to facilitating change and adjustment to the emerging new regime, or should I continue to lend to support the more controversial activities of my customers?
  • Where does loyalty to my customers end?
  • Do I need to establish limits in my exposure to sectors that are under increased environmental and social pressure?
  • Does increased political focus and lobbying pressure change the risk profile of the economic sectors of borrowers?
  • If I choose to exit financing certain industries, how would I replace that revenue?
  • When exiting industries or relationships, how do I deliver the message to manage reputational risk?

Regulators expect that risk management is a core competency of the commercial lending business. This means that the ESG impact on credit and revenue risks must not just be considered in the C-suite, but embedded in business operations. There is an important role to play for each of the three risk lines of defense, from the business units to the compliance and risk officers to the audit team.

From a supervisory perspective, bank and securities regulators are going to ask three key questions that will inform the future regulatory agenda for ESG.

  • Where are the firms in terms of managing, reporting, and properly disclosing ESG impacts on credit risk management?
  • How do ESG considerations influence what constitutes sound lending practices?
  • What are the near- and longer-term risks?

While the precise timing and methods by which regulators and supervisors tackle these questions are still unclear, it is likely that they will conduct a series of horizontal examinations to compare and contrast practices across firms. This horizontal examination process will then inform their understanding of what constitutes best practice and where there is scope for improvement. From these reviews they can then begin to assess how risk management should incorporate emerging ESG issues on a sustainable basis. While it is unclear how fast regulators and supervisors will be able to push this agenda forward, banks should anticipate that a clear set of supervisory expectations for ESG will emerge over the next few years.

This the first of two opinion articles by the authors about ESG challenges facing banks. Coming Friday: What regulators will expect.

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