FAQ: ESG risk management for banks

ESG risk management is a top concern for risk and credit officers. Is your bank prepared to meet the challenges?

Environmental, social, and governance (ESG) issues have quickly made their way into the action plans and initiatives of financial regulatory agencies. Bank risk officers and credit officers are discerning how forthcoming regulatory rules will affect their organizations, how to get started on an ESG strategy, and what specific steps they should be taking to meet their ESG risk management responsibilities. Here are answers to some frequently asked questions.

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What ESG-related regulatory requirements are in store for banks?

As the Securities and Exchange Commission (SEC) refines its proposed climate disclosure rule and other agencies, such as the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp., release guidance regarding climate risk management, banks should start preparing for anticipated reporting requirements such as disclosure of how a company assesses, manages, and governs climate-related financial risk. Furthermore, based on the SEC's spring 2022 regulatory agenda, proposed rules related to ESG have grabbed the attention of regulators, including rules on corporate board diversity, human capital management disclosures, and cybersecurity disclosures. As such, monitoring and assessing bank ESG regulatory developments is critical, as various agencies finalize their reporting requirements and specifics quickly change.

What are the real business risks associated with ESG?

Each component of ESG potentially exposes banks to a specific set of business risks. These ESG risks can be organized into three basic categories:

Reputational risks

When a bank begins implementing changes in strategy and reporting to address ESG issues, it encounters reputational risk related to the information it discloses publicly. ESG-related disclosures must be supported, validated, and reported clearly, accurately, and consistently with a bank’s mission and strategy. The rise in environmentally and socially conscious investors, customers, and employees and the evolving regulatory landscape mean greater scrutiny of the validity of ESG-disclosed information.

Transition risks

Transition risks in the environmental realm include the costs a bank could incur in shifting to a lower carbon or carbon-neutral operating model, which requires changes in policies, procedures, and processes. The social aspects of ESG also entail transition risks as banks restructure their lending strategies and credit policies to improve service levels to traditionally underserved communities. Diversity-driven changes in hiring, promotion, and other personnel practices can generate additional transition risks. Substantial transition risks are also associated with the governance component of ESG, which involves compliance with rapidly changing regulatory regimens covering a broad range of issues.

Physical risks

In terms of physical risk, banks should recognize and evaluate steps to mitigate climate change-related risks to their own facilities and to customer property or other physical assets that have been used to secure loans.

How can banks establish perspective regarding their ESG risks?

Banks should determine how ESG contributes to their overall business strategy and evaluate the risks and opportunities from an enterprise risk management perspective, including what concerns their stakeholders consider as most significant. A thorough materiality assessment can help bank leadership better understand how specific ESG risks and programs relate to the organization’s business purpose, strategy, and stakeholder priorities.

How does climate risk manifest itself in the credit portfolio?

Credit risk ultimately is exhibited through transitions and physical risks associated with climate change. In addition to potential physical damage to secured properties from storms and other immediate risks, lenders also must consider longer-term aspects of climate risk, such as sea level rise or coastal erosion in future years. For example, banks might need to adjust credit policies to mitigate risk from a heavy concentration of properties in a single geographic area.

In the same way, banks might need to modify their commercial loan portfolios to limit excessive exposure to industries that could be subject to more stringent environmental regulation or climate-related disruptions, such as the energy, agriculture, and transportation sectors.

From a governance perspective, banks must address additional regulatory pressure to develop plans for mitigating the financial risks associated with climate-driven credit issues. Compliance with mandated flood insurance programs is just one current example of climate-related issues’ impact on the credit portfolio.

Is ESG focused solely on risk avoidance? Or does it also offer opportunities?

Effective ESG initiatives can open or enhance opportunities for banks of all sizes. From the environmental perspective, new technologies – from electric vehicles to renewable energy – present several new lending opportunities. Banks also might participate in incentive programs to encourage the financing of clean energy and reduced carbon emissions in various industries. In addition to financial opportunities, such programs also offer opportunities to boost an organization’s positive profile among key audiences.

In the social area, one example is the opportunity to broaden a bank’s customer base through targeted engagement with local communities. In addition to generating growth outright, such engagement can also help mitigate risk, since a more diverse loan portfolio presents a lower inherent risk profile than one that is highly concentrated in a single area or group of customers, leading to a healthier socioeconomic footprint. In a similar way, a more diverse workforce can bring in fresh perspectives and recognition of opportunities that might otherwise be overlooked.

Further, in order to meet the enhanced governance and disclosure requirements that regulatory agencies are now developing, banks will need to compile various types of new data, sourced both internally and externally. These data points have inherent value and can be used as tools for sustainability planning and developing long-term growth strategies. For example, quantitative data on greenhouse gas emissions can help banks develop new mortgage products that incentivize the use of sustainable materials or other financing tools that support greater energy efficiency or reduced carbon emissions.

How do I assess ESG third-party risk?

Many banks are forming dedicated ESG teams to help manage efforts; however, it is likely that various team functions will require outsourcing if required subject-matter expertise is not available internally. For example, certain aspects of climate risk assessments, climate risk modeling, or scenario analysis and reporting might require third-party involvement. Since this arrangement opens up additional areas of third-party risk, banks should take particular care to perform thorough due diligence. Risk officers or teams should be sure they understand their third parties’ data quality standards, their validation processes, and specific controls that relate to their scope of work.

Successful and sustainable banks need to be sensitive to the practices of their vendors and other third parties since the behaviors of parties associated with a bank can quickly affect the bank’s reputation. Banks should take proactive steps to understand their third parties’ ESG practices and how they are managing related risks.

What should I be doing right now about ESG issues? Where do I start?

There is no single right approach that applies to all organizations. Each bank should gather a committed, integrated, and cross-functional team to create a holistic ESG strategy that is specifically designed to address the bank's particular risk profile and consider all stakeholders. While each strategy is unique, a structured approach can help bring focus to the effort.

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