Green Banking: Integrating ESG Criteria into Credit Decision Processes

In 2020, the European Banking Authority (#EBA) had published their #Guidelines on #Loan #Origination and Monitoring, which are now being implemented across Europe. In Germany, for instance, requirements formulated in the Guidelines have been added to the latest iteration of the Minimum Requirements for Risk Management (#MaRisk).

One element of these requirements is for banks to consider Environmental, Social, and Governance (#ESG) factors as part of their credit risk assessment processes. Specifically, the guidelines state that banks should consider "the environmental and social impact of the project or activity to be financed and of the borrower or group of borrowers" when assessing the creditworthiness of a borrower.

The reason why ESG criteria are worth integrating into the assessment of credit quality is that they can impact a company's financial performance and risk profile, both of which are clearly in focus from a regulatory perspective.

For example, companies that have strong environmental practices may be better positioned to manage risks related to regulatory changes and resource constraints, while companies with strong social and governance practices may be less prone to reputation and legal risks. By considering ESG criteria in their credit decisions, banks can gain a better understanding of these risks and how they may impact a borrower's ability to meet its financial obligations.

There is also increasing evidence that companies with strong ESG practices may be more financially successful in the long term. For instance, a study by MSCI found that companies with strong ESG ratings outperformed their peers by 3.5% per year on average over a 10-year period. This study analyzed over 7,000 companies across developed and emerging markets. Sustainability data provider ESG Book has also shown regional model portfolios consisting of stocks with higher ESG scores consistently outperforming their benchmarks.

This because strong ESG practices can lead to increased efficiency, reduced costs, and improved customer and employee relationships, all of which can contribute to a company's financial performance.

From a credit risk perspective, stronger (yet not hysterical) stock performance is typically a sign of lower default probability - which means considering ESG criteria in credit decisions is not just a question of regulatory compliance with EBA rules, but is is also good business practice.

In our experience, however, ESG criteria have not yet been consistently integrated into credit processes by most firms. Typical issues encountered in the implementation process are the following, which often lead to delays:

1. Lack of #Standardization: There is currently a lack of standardization in the way that ESG data is collected and reported, which can make it difficult for banks to compare the ESG performance of different companies and incorporate this information into their credit analyses.
2. Limited availability of #ESGData: There may be limited availability of ESG data on some companies, particularly smaller or less well-known firms, making it difficult for banks to fully assess their ESG performance.
3. Inconsistent definitions and #Metrics: Different organizations may use different definitions and metrics to measure ESG performance, making it challenging for banks to compare and assess the ESG performance of different companies.
4. Limited integration with existing #CreditRiskManagement systems: Integrating ESG criteria into the credit decision process may require banks to make changes to their existing credit risk management systems, which can be a challenge.
5. #Resource constraints: Assessing the ESG performance of companies can be resource-intensive, requiring banks to allocate additional time and resources to the credit analysis process.

Overall, these challenges certainly make it difficult for banks to effectively integrate ESG criteria into their credit decision processes in a consistent and systematic way. However, these challenges must be overcome in short order. And to do that, there are a number of steps banks can take. In particular, we would suggest the following activities that will also help addressing a series of additional pieces of ESG-related #Regulation, particularly in the #EU, in a consistent manner:

1. Select third-party ESG data and ratings sources: To help overcome the lack of standardization in ESG data and the limited availability of ESG data on some companies, banks can use third-party ESG data and ratings provided by organizations such as Sustainalytics, MSCI, and Bloomberg. These organizations can provide standardized, reliable ESG data and ratings that can be used as part of the credit analysis process.
2. Establish internal #ESGTeams or units: Banks can establish internal teams or units dedicated to ESG analysis to help assess the ESG performance of companies and integrate this information into the credit decision process.
3. Develop internal #ESGFrameworks and metrics: To overcome the challenge of inconsistent definitions and metrics, banks can develop their own internal ESG frameworks and metrics that are tailored to their specific risk appetite and lending activities.
4. #Collaborate with other banks and industry groups: Banks can collaborate with other banks and industry groups to share best practices and approaches to integrating ESG criteria into the credit decision process.
5. Invest in #Training and #Education: Banks can invest in training and education to ensure that their credit analysts and other staff have the skills and knowledge needed to effectively assess the ESG performance of companies and incorporate this information into the credit analysis process.

In summary, integrating ESG criteria into the credit decision process is not only a regulatory requirement formulated by the EBA and now introduced in most European jurisdictions, but is is also good business practice. And while banks are naturally facing challenges in the corresponding implementation project, there are some key steps that help not only facilitate the integration - but also support other upcoming regulatory ESG initiatives.