Mention environmental, social and governance (ESG) risks — often the first sector that comes to mind is an extractive industry like mining or resource-intensive enterprises like manufacturing and construction. One less-acknowledged industry: financial services.
Yet, ESG risks for banks and other financial institutions can also be highly complicated and mission-critical, requiring diligent and informed board oversight.
Not only do banks consume resources and have an environmental footprint like any business, but many also provide financing to infrastructure, building and other projects that impact the environment. Banks' lending policies have a social impact — from the negative impact of discriminatory lending to the positive impact of green building loans. And the ability of a bank's governance practices to prevent or flag activity like money laundering or currency manipulation can have a major impact on the bank's reputation, regulatory standing and revenues.
ESG Risks for Banks: A Rising Vulnerability
Increasingly, a poor ESG 'risk score' is noticed by regulators, customers, rating agencies, investors and business partners. Concurrently, 'Awareness is also growing that responsible banking approaches and skillful management of ESG can improve risk-adjusted returns, enhance reputation, spark commercial opportunities, mitigate portfolio risks, and improve market positions and value,' writes KPMG Global.
More and more bank boards are recognizing the need to factor ESG risks into their oversight of investments, lending, procurement, project financing, products, services and other practices.
Successful management of ESG risks are a matter of maturity. Making the right decisions on governance structure, investment policies, research and credit risk processes, disclosures, and other important factors requires banks to ask the right questions and collect the right ESG data in a timely fashion.
It's also a matter of materiality. Determining which ESG risks are most relevant to each bank's operations and stakeholders and which ones are most impactful in terms of cost, risk and growth are critical for bank boards of directors.
Narrowing in on ESG risks for banks often requires a gap analysis, customized to a specific organization. It can be helpful to focus first on a few overarching areas, such as regulatory requirements, voluntary guidelines and the environmental, climate and disaster, and social issues.
Five Places Banks Should Look First When Assessing ESG Risks
1. Regulatory Requirements
From the Sarbanes-Oxley Act of 2002 to the financial reforms that followed the 2008 economic crisis, global crises are typically followed by heightened regulator and legislative oversight, particularly for financial institutions. Banks should expect similar developments and increased enforcement in response to the COVID-19 pandemic.
As one example, ABA Banking Journal notes that UDAAP (Unfair, Deceptive, or Abusive Acts and Practices) enforcement actions may be an area of focus as banks introduce new products and innovations in a business environment made increasingly competitive by COVID-19 and fintech-driven digital transformation. Tools for taking action: Boards can identify potential UDAAP red flags by evaluating how banks live up to the promises of marketing programs and analyzing customer complaint data. Centralized corporate records delivered via an entity management system provide visibility and transparency into licenses and registrations for stronger overall compliance.
2. Voluntary GuidelinesMany banks are concurrently adopting voluntary guidelines such as the Equator Principles, UN Principles for Responsible Banking, and the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD) to keep up with evolving regulations. Early adopters can gain a powerful competitive advantage in the marketplace and a valuable framework for building and enforcing ESG policies. Following the guidelines, however, requires time, commitment and resources. Tools for taking action: Bank directors can track ESG standards, trends, regulations and guidelines using business intelligence tools. This enables directors to identify red flags and keep management and fellow board members informed of anything that needs to be addressed or changed.
3. Environmental Issues
The 'E' in ESG is both ascending and expanding as a priority for banks and other financial institutions.
Activists, consumers and institutional investors like BlackRock are using proliferating standards to examine businesses' environmental impacts with additional scrutiny. At the same time, the World Economic Forum guidelines could lead to standardized environmental benchmarks for each industry. Changing guidelines increases the need for boards to oversee their bank's operations, from green bonds to mortgage loans for energy-efficient homes.
Tools for taking action: Digital platforms can help banks set goals for environmental requirements and track their progress towards them. Banks can start by building protocols for risk management, improvement planning, internal audit solutions, and a comprehensive library of standards. Meanwhile, banks can compare their impacts against their peers' using data analytics that measure low-carbon patents or amounts of 'green' revenue.
4. Climate Change and Disaster Risks
Extreme weather events ravaged Europe in 2019. In a single year on a single continent, flooding cost $3.5 billion in damages in Italy, while in Spain droughts cost $1.7 billion, and floods cost $2.5 billion.
Recognizing the sweeping business impact, the UN Office for Disaster Risk Reduction is calling for credit rating agencies to explicitly integrate sustainability factors into their assessments. It also calls institutional investors, asset managers, and company directors to integrate disaster risk reduction, climate change adaptation, and resilience into their decisions.
Tools for taking action: As in other ESG risk areas within the banking sector, integrated governance platforms can help bank boards stay ahead of new developments trends, flag ESG issues in their operations, and track progress against ESG goals.
5. Social Risks for Banks
Consumers and investors alike are watching where banks invest their money, what they prioritize in terms of diversity, equity and inclusion, how they treat their customers and employees, and more. Some of the 'S' in ESG is encoded into official guidelines. The Equator Principles, for example, include robust standards for indigenous peoples, labor standards, and consultation with locally affected communities. Others are a matter of evolving stakeholder sentiment.
Tools for taking action: Corporate governance intelligence tools can help bank boards stay current with both evolving frameworks and public opinion on being a good corporate citizen and ensure their company's actions keep pace with both.
How Strong Governance Is Vital to Mitigating ESG Threats in Banks' Boardrooms Today
Leadership cuts across all areas of ESG risk management and mastery. How does your board composition compare to your peers? What skill sets is the board lacking? What conflicts of interest might your investors have uncovered?
To answer these questions successfully, bank boards need to bring the right people into the room and support them with the policies, processes, and resources for timely, sharp decision-making.
Tools for taking action: Governance analytics programs allow boards to set and mark progress against benchmarks like ethical internal governance, as well as identify gaps in skills, composition, and diversity.
As ESG risks for banks evolve and escalate, timely, effective solutions can help boards stay ahead of the issues. Download an ESG roadmap from Diligent today.