Banks Must Introduce ESG Compliance in Retail Loan Portfolio By-Hargovind Sachdev

A Retail loan is provided to an individual, trader or a small industry by a commercial bank to purchase property, vehicle, machinery or meet working capital requirements. MSME industries and Traders also form part of the retail loan portfolio. In March 2022, Rs 89 lakh crore was outstanding under retail loans. Banks disbursed Rs. 24 lac crore loans from April 2021 - March 2022. Year-over-year growth in active retail loans was 46% between March 2021 and March 2022. The rise in loans reflects the galloping consumerism in Indian society and the appetite of small industries and traders for credit. It also reflects the significant role played by the retail loan portfolios of banks in the Indian economy.?

Due to its size and increasing potential, the retail loan portfolio needs risk management strategies similar to the wholesale loan portfolio.?Recent events show that apart from the Credit, Market and Operational risks, Climate risk also affects the status of retail loans adversely. Banks must, therefore, urgently introduce ESG compliance in retail loans to avoid stress in this exponentially growing business segment.?

With the RBI easing the quantum of repo rate hikes, various banks face a compression in net interest margins in 2023-24 (April-March) as the re-pricing of deposits occurs slower than loans. Hence, focusing on high-yielding, less risky retail loans with an eye on climate risks shall protect the net interest margins.?Banks must incorporate Environmental, Social, and Governance (ESG) compliance in the Rating Rationale of retail loan portfolios while assessing the risk profile.?

In response to the Paris Convention on Climate Risk, India has committed to restricting the increase in temperature within 1.5 degrees of the pre-industrial era by the year 2030. By financing thousands of diesel cars, generators, and polluting MSME industries, Banks are rapidly adding to the increase of greenhouse gas emissions.

?Our window for limiting warming to 1.5°C is closing fast. Considering the meteoric growth of the retail loan segment, the time is ripe to bring regulations to deny loans to polluting activities.?

For businesses, bridging the gap between commitment and action is easier said than done. To drive meaningful climate action and bridge the gap, banks have to come forward to enforce the implementation of ESG norms on small and medium industries as well. All long-term loans should elicit commitments from borrowers to reduce emissions.?

When it comes to retail lending, several loan products must prescribe compliance with Environmental, Social, and Governance (ESG) guidelines. Here are some examples:

Green loans: These are specifically designed to finance environmentally friendly projects such as renewable energy, energy-efficient buildings, and sustainable agriculture. Green loans can help individuals and businesses reduce their carbon footprint and meet ESG objectives.

Socially responsible loans: These loans are designed to support projects with a positive social impact, such as affordable housing, education, and healthcare. These loans can help promote social equality and economic development.

Microfinance loans are small loans provided to individuals or small businesses, especially those in low-income communities, to help them start or expand their businesses. Microfinance loans promote financial inclusion and economic empowerment.

Personal loans for sustainable purchases: These loans are designed to finance purchases of environmentally friendly products, such as electric cars or solar panels. They can help individuals reduce their carbon footprint and promote sustainability.

Community development loans support community development projects such as community facilities, supply chain support loans and small business development. Community development loans can promote economic growth and improve the quality of life in communities.

Banks should develop and implement ESG policies and guidelines aligned with their business objectives and values. These policies should cover all aspects of retail lending, including product design, underwriting, and portfolio management. Banks should conduct ESG risk assessments to identify and evaluate the potential ESG risks associated with their retail lending activities. This should include an analysis of the impact of climate change, social issues, and governance practices on the borrowers and the bank.

Banks should integrate ESG considerations into their underwriting and credit decision-making processes. This could involve using ESG criteria to evaluate the creditworthiness of borrowers, including their sustainability performance and social impact. Banks should regularly monitor and report ESG performance in their retail lending activities. This should include measuring the impact of their lending activities on the environment, society, and governance practices and reporting on progress towards their ESG goals and targets.

Banks should engage with stakeholders, including borrowers, investors, regulators, and civil society organisations, to understand their expectations and concerns regarding ESG issues in retail lending. This engagement can help banks identify and address potential ESG risks and opportunities. There are five compelling reasons to impose compliance with ESG norms in the retail loan portfolio of banks:-

1. Mitigate Risks: ESG factors, such as climate change, social inequality, and governance issues, can have a significant impact on a borrower's ability to repay a loan. Banks can mitigate risks and avoid losses by incorporating ESG factors into lending decisions.

2. Meet Regulatory Requirements: Many countries have incorporated ESG factors into regulatory frameworks. Indian banks not complying with these regulations may face penalties or reputational risks while accessing international markets for funding.

3. Address Stakeholder Expectations: Stakeholders, including overseas investors, customers, and employees, increasingly demand that banks adopt sustainable practices. By incorporating ESG factors into lending decisions, banks can demonstrate their commitment to sustainability.

4. Improve Brand Reputation: Banks adopting ESG compliance in their retail loan portfolios can enhance their brand reputation globally and attract customers concerned about environmental and social issues.

5. Enhance Long-Term Business Viability: Incorporating ESG factors into lending decisions can help banks identify long-term business risks and opportunities. Banks can support MSME businesses that significantly increase exports and GDP by funding individuals and small industries committed to sustainability.

By implementing robust ESG policies, conducting risk assessments in credit decision-making, monitoring and reporting and engaging with stakeholders, banks can ensure compliance with ESG guidelines to protect their retail lending assets.