ESG Risk Management for Banking

IN THIS ARTICLE

Are banks exposed to ESG risks?

What are the climate related ESG risks for banks?

What are the social and governance risks for banks?

How to manage ESG risks for banks and other financial institutions

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Are banks exposed to ESG risks?

Banks may be exposed to ESG and climate risks directly through their own operations and indirectly through services provided to their clients (e.g., financing clients in controversial industries). If not managed well, these risks can negatively affect the organization’s financial performance and credit, as well as their reputation.

Increasingly, banks and other financial institutions are pressured by legislators, regulators, and society to better manage and disclose these risks, in both the EU and the U.S.

Financial institutions are often categorized as banks, insurance companies, asset managers, and asset owners. This document focuses mainly on banks, with some examples of climate-risk management for insurance companies. Throughout the document, ESG risks also include climate risk.

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What are the climate related ESG risks for banks?

Climate risks are often categorized into physical risks and transition risks.

Banks can be exposed to the physical risks of climate change when severe weather events like floods, fires, and hurricanes result in borrowers’ damaged assets being devalued. This could lead to increased loan default rates, resulting in increased credit risk. In addition, banks that hold collateral assets of fossil-fuel or other carbon-intensive industries may face transition risks of climate change and stranded asset risks. For example, the introduction of a new climate regulation could reduce the demand of fossil fuels, thus devaluing coal reserves.

Insurance companies may also be negatively affected by both physical and transition risks through their underwriting and investment activities. For instance, the value of their real estate portfolios located in areas facing increased physical risk of climate change could be decreased. The NYDFS issued an Insurance Circular Letter asking NY domestic and foreign insurance companies to integrate climate risks in their risk management and governance frameworks, as well as business strategies.

Practice Tip: Best practices include identifying climate risks across all asset classes, sectors, and geographies of a portfolio. Assets in certain jurisdictions could be more vulnerable to the impact of physical risks of climate change such as droughts and sea-levels rise than others.

Nature-related risks (e.g., biodiversity loss) may expose financial institutions to increased risks such as credit and reputational risks through their operations or services. For example, a company that causes damage to natural resources or biodiversity could be exposed to litigation. As a result, the company’s assets could be tied up, resulting in loss of revenue, production, and eventually slowing or stopping overall operations. This would expose financial institutions to credit risk, as it affects the company’s ability to repay its loans. Additionally, financial institutions that lend to or invest in companies or projects that cause biodiversity loss may suffer reputational damage and risk losing new business opportunities as customers may opt for financial institutions with a better reputation for sustainability.

A group of financial institutions and private firms formed the Taskforce for Nature-related Financial Disclosures to develop guidelines for the financial sector to better understand and disclose how they manage risks related to biodiversity loss.

What are the social and governance risks for banks?

Financial institutions may be exposed to social and governance risks through their own operations or their services. Poor corporate governance practices (e.g., lack of effective board oversight or procedures to monitor and control risks) could adversely affect their financial stability and reputation.

Banks that fail to manage and control a workplace safety risk, which is considered a social risk, could be exposed to liability and reputational damage. Additionally, banks that lend to or invest in companies engaged in human rights violation or companies with poor corporate governance practices may suffer reputational damage and lose new business opportunities if customers opt for banks with a better reputation for sustainability.

How to manage ESG risks for banks and other financial institutions

1. Check that a board member or someone in senior management oversees the assessment and management of ESG risks for banking.
2. Integrate ESG risks into your existing risk management framework. Banks can refer to the OECD Guidelines to carry out ESG due diligence systemically to ensure responsible corporate lending.
3. Integrate ESG risks into your credit risks analysis as part of the lending or investment decisions, at customer and transaction level, and at portfolio level.
4. Disclose ESG risks to appropriate stakeholders. For climate risk disclosure, refer to the Task Force on Climate-related Financial Disclosures (TCFD)’s supplemental guidancefor the financial sector. The Sustainability Accounting Standards Board (SASB) also provides disclosure recommendations for seven industries within the financial sector. For example, it recommends commercial banks disclose how they incorporate ESG into their credit risk analysis in their sustainability report.