Environmental, social risks to impact banks’ investment, lending decisions
The impact of these developments on banks’ credit strength will depend on how quickly these changes take place, with longer time frames giving banks greater opportunity to adapt.
Environmental risks are expected to become more important for banks’ investment portfolios in the future with new climate policy changes and the promotion of the low carbon economy, according to a new report from Moody’s Investor Service report.
The impact of these developments on banks’ credit strength will depend on how quickly these changes take place, with longer time frames giving banks greater opportunity to adapt. It will also depend on the level of engagement that policymakers and regulators seek from banks to meet their environmental objectives.
The internal operational exposure of banks to environmental risks is generally low as their own environmental footprint does not typically raise credit concerns. But banks can be exposed to environmental risks indirectly through their investments and lending decisions. Air pollution, soil/water pollution, carbon regulations, water shortages and natural and man-made hazards are the environmental risks that might have the most impact on issuers’ credit quality.
Climate-change related risks are challenging to assess as they have developed over a long or uncertain period of time, and are subject to a variety of potential policy measures and economic growth scenarios. This can result in a wide range of potential credit outcomes for affected companies, increasing credit risk volatility in the banks’ investment portfolios.
Social risks can be encountered by banks through their integration with stakeholders and society at large. Social risks generally have a moderate impact on banks’ credit quality and typically affect credit quality through litigation, reputational, and regulatory channels. For instance, global investment banks have built up close to US$290 billion of provisions against potential litigation charges in the financial crisis in 2008.
Social policy agendas that lead to regulatory changes are likely to affect banks’ revenues and credit standards. For example, land reforms in South Africa include a proposed change to the constitution to allow for expropriation of land without compensation, which has potentially reduced the value of the collateral backing many bank loans, putting more pressure on banks’ cost of risk.
Governance risks are well-established drivers of banks’ creditworthiness. Governance quality is particularly important for banks as they operate with higher leverage and are more confidence-sensitive than corporates, particularly regarding their funding arrangements. A poor governance framework can lead to a severe deterioration in asset quality and will affect profitability due to the incurring of fines or regulatory sanctions from governance breaches.
All banks worldwide are exposed to ESG risks, the types of exposure and its impact on credit varies by region. Governance risks are generally relevant for all banks. Developed countries are exposed to higher social risk particularly litigation risk as a result of misconduct. Physical exposure to environmental risks is higher in developing countries, which tend to be more reliant on agriculture and affected by the increasing severity of natural disasters.
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