Sustainable Finance and the new role of banks
International organizations have been trying to influence the sustainability of the economy for years. Despite the accelerated growth of activities in this area, this topic still remains on the side lines of strategic focus and business practices. Due to the lack of overview and established standards, the transition to sustainability is associated with many uncertainties and risks. Besides numerous discussions, conferences and publications, one thing has become clear: the financial sector will play an essential role here. In Europe, the banking sector, as the most important money and capital flow distributor, cannot be left untouched.
For years banks have been seen as the necessary evil for economic growth and have been blamed for the greatest losses of our century. With society's growing awareness of the risks associated with climate change and unethical business practices, banks in particular can become the instrument to stimulate a sustainable economy and safeguard global prosperity. The advancements in risk management and stress testing can be well used here.
Due to the specific importance of the banking sector for economic activities, the credit institutions have finally the chance to prevent coming crises instead of causing them. For the first time since 2008, banks can build a reputation on improving bad practices of other economic actors and indirectly steer the overall ESG risks. Further value added from the transition towards sustainable finance lies in the possibility to enter businesses in new markets/products and to become profitable in the current low interest rate environment. From a regulatory perspective banks will be preferred, if they re-balance faster and more efficiently, meet expectations and help to set industry standards.
Almost four years have passed since the UN summit and the Paris Agreement, which called for a redistribution of financial flows to meet environmental and socio-political goals. Although the UN Sustainable Development Goals (SDG) and the Paris Agreement are aimed at a broader audience, supranational and national institutions in particular have taken high-level implementation initiatives, while a large number of stakeholders have remained rather inactive or inert.
Creating a political framework in accordance with the sustainable goals, which ensures both, a level playing field of financial institutions and market stability, is not an easy task. Thus, the European financial regulators refrain from binding requirements towards banks and instead rely on recommendations or high-level expectations on the financial sector. It appears that the providers of financial services do not like to internalize external environmental costs.
To strengthen the capital market union towards sustainable future, the EU has developed an action plan including the consideration of ESG risks in investment decisions. This is the first step in Europe, but again only as a high-level planning. The actual execution will be noticeable in the coming years.
Action Plan ≠ Action
Understanding of ESG Risks is important for financial stability as they can lead to high losses. With the so-called Green Swan Events, BIS describes extreme scenarios for systemic risk, which should be explained by integrating sustainability aspects into risk management and by coordinating several actors for better understanding of forward-looking analyses [1]. A basic distinction is made between transition and physical risks. The taxonomy developed by TEG is intended to introduce uniform standards for the classification of economic activities.
At the EU level regulations and technical implementation standards should ensure that financial institutions redirect capital flows for sustainable economic activities so that the EU Green Deal is facilitated. In the meantime, the global initiatives are plenty and at a high strategic level, so that BaFin has recently only worked out a recommendation guide for financial institutions [2]. In Austria, the FMA is drafting guidelines as non-normative support for financial institutions in dealing with sustainability risks [3].
The only binding legislation at European level is currently the EU Disclosure Regulation [4], but only applicable for investments and funds at the professional capital market and not for traditional credit financing (e.g. in the field of SMEs).
Other initiatives are aimed at integrating climate risks into regulatory stress testing. The IMF also calls on central banks worldwide to engage in simulations of environmental risks [5]. The EBA will conduct a sensitivity analysis in 2020 as part of its regular program in form of Climate Risk Stress Test on a voluntary basis [6]. The BoE also plans to introduce a Climate Stress Test.
Despite increased regulatory attention and awareness of ESG risks, the proportion of sustainable investments remains relatively small and therefore in the niche market, even if growth has been at its highest level in recent years. The market differentiates between sustainable investments (SI), responsible investments (RI) and socially responsible investments (SRI).
The FNG has carried out a market study on sustainable investments in the German-speaking countries. Above all, the proportion of private investors is low (7% for Germany and 20% in Austria), which indicates that retail customers have limited access to this market and are only served through niche products. Even if the financial benefits are statistically proven [7], investors (banks included) consider such long-term and rather stable investments to be unsafe and refrain from becoming active market participants.
The lack of transparency towards customers is another problem. The saving and deposit products cannot be traced into which environmentally and sustainability-related activities and sectors are flowing through lending. There are rating agencies (e.g. Inrate, Sustainalytics, ISS, Fitch etc.) that also use their own methodologies. However, they are still highly fragmented and their information is not publicly available to increase transparency and generate impulses on the market.
With the current regulatory situation, the main driver for the transition to sustainable finance should come from the market. Currently more than half of EU citizens are ready to invest in green investments [8], which indicates an enormous market potential. The demand for sustainable investments and financing puts credit institutions in need of meeting them and developing appropriate strategies, product offerings and risk management practices. In this case, the banks should settle better in the role of market makers and actively promote this development. First, they should provide information and transparency of the ESG risks. This concerns also the assessment of transition risks. Banks must do more than just operational ecology for their own company.
The opportunities for banks that are pioneers in this development result from the possibility to invest money from low-cost private products (e.g. demand from environmentally conscious retail customers) in favourable credit and project finance.
At present, there are hardly any traditional customer products such as loans and deposits that take sustainability aspects into account.
The long-term trend requires the financing of sustainable loans as a success factor. That is why first movers will benefit most from financing companies and projects that are already sustainable and until market saturation is reached. It will be then more difficult for the late comers to comply with heightened standards and regulations later. Knowledge building and understanding of the ESG risks and the associated opportunities are essential for the market.
Currently there are investment strategies in the investment area. These include screening, which means the classification of assets (investments) according to certain criteria, such as industry, corporate practices, country, but also relative assessments of sustainability (best-in-class, best-in-progress). In addition, an evaluation of the ESG risks and/or of the environmental impact can be made. The latter takes the entire value chain into account.
In addition to the establishment of governance structures and the introduction of guidelines, the corresponding human resources must also be used to implement such strategies. Areas such as risk management should have a special focus on the ESG factors in the entire end-to-end process chain. When developing new products, there will be a great need for qualified consultant training [9].
A long-term perspective is fundamental and goes beyond the short-term (1 year) or medium-term (3 to 5 years) time horizon [10]. Since this is one of the biggest challenges, it implicates reorientation of the business strategy and revision of the risk management framework. This change is even more difficult because long-term financing will increase the risk of maturities mismatch and due to possible lack of hedging instruments.
In their classic role in risk transformation, banks can also assume ESG risks by providing more market transparency, steering impulses and redirecting the capital flows. An important point for banks is the enormous effect on the reputational risk, which can be reduced through higher awareness and transparency, as well as better handling of ESG risks.
RISK CONTROL: Essential for banks to handle ESG risks is building risk management capacities. First, technical resources for the analysis of the business portfolio and customer profiles regarding sustainability should be allocated. Corresponding governance management structures should be set up. These activities can be carried out based on a preliminary study and a feasibility study for implementation. An adoption and translation of the EU taxonomy should enable banks to develop their own rating and classification procedures in order to evaluate the existing business and to steer new business. The ESG risks can be integrated uniformly in the 3-LoD model. In this way their amount can still be measured in the lending or investment process. With the development of appropriate risk management methods, new sustainable financial products can also be created. The whole should of course be integrated into the business and risk strategy, risk appetite and governance. Creation of internal guidelines and process adjustments are another important instrument for the transformation of banks. The availability of sufficient data and adequate technical systems should also support this process.
STRESS TESTING: By using scenario analysis and stress testing banks can gain better understanding of their own stability against ESG risks and develop risk-reducing measures. A challenge is the adjustment to long-term perspective (such as the 30-year horizon proposed by BoE) that requires specific assumptions and data, which unfortunately cannot be validated by historical observations. In this case banks should primarily rely on scenarios developed by the supervisory authorities and apply them according to their business model and internal methods. Voluntary participation in the 2020 sensitivity analysis carried out by the EBA will at the same time provide better insights into the simulation of climate risks and the regulatory expectations thereof.
EDUCATION: Knowledge and competence in the physical and transition risks are essential for every credit institution. In order to be able to offer customers informational advantage and risk transfer or assumption, the banks should be able to understand the connection between the financial losses and the ESG risks. This means that they face completely new challenges of understanding and evaluating global climate and socioeconomic processes.
Despite increased regulatory attention and awareness of sustainability issues, the ESG risks are still not barely understood, recognized and measured by the financial industry. Credit institutions need even more triggers, both from the regulators and particularly from the market, to play a crucial role in capital allocation to sustainable activities. A long-term perspective in business planning can only be implemented strategically and operationally with the appropriate risk management framework. This requires fundamental changes in the areas of risk controlling, stress testing and knowledge acquisition in sustainable finance.
References:
[1] The green swan - Central banking and financial stability in the age of climate change, BIS, Jan 2020
[2] Merkblatt zum Umgang mit Nachhaltigkeitsrisiken, BaFin, Dez 2019
[3] Sustainable Finance – Aktuelle und zukünftige Anforderungen der Aufsicht für das Management von Klimarisiken, FMA, Dez 2019
[4] 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
[5] Climate change and financial risk, Grippa et al., IMF, Dec 2019
[6] Action Plan on Sustainable Finance, EBA, Dec 2019
[7] Nachhaltige Kapitalanlagen – eine Einstiegshilfe, Nov 2019
[8] Citizens’ commitment to fight climate change in 2020, EIB climate survey, Jan 2020
[9] Marktbericht Nachhaltige Geldanlagen 2019, FNG, Jun 2019
[10] Report on undue short-term pressure from the financial sector on corporations, EBA, Dec 2019nce and the new role of banks
