How banks can tackle sustainable lending, in 4 charts
- Banks may find themselves having to increasingly employ sustainability measures into their lending practices, an Accenture report found.
- Regulators will pressure those falling behind sustainability criteria, while those who take the lead into such endeavours could enjoy a better reputation, higher valuations and even better financial performance.
In the wake of the climate crisis, banks’ lending practices are getting more attention as the financial sector comes under pressure to reduce its support for fossil fuels.
According to a study by Banking on Climate Chaos, the world’s 60 largest commercial and investment banks lent a total of $3.8 trillion in fossil fuels from 2016 – 2020. JPMorgan Chase headed the charts as the world’s top banker of fossil fuels, lending $317 billion in the five-year period. The next three top fossil fuel financiers were also US banks, namely Citi, Wells Fargo and Bank of America.
Considering this landscape against the pressures coming from regulators, banks may find themselves having to increasingly employ sustainability measures into their lending practices, an Accenture report found.
But due to a lack of clear standards and regulations, many banks worry about assessing the risk of unproven business models and technologies, as well as longer payback periods, the report argued. Moreover, as the ESG industry is still in its nascent stages, there are also concerns about the maturity of some organizations and projects in the sustainable lending category.
Even though most banks are still unclear on what the advantages of sustainable lending are, falling behind the environmental narrative could translate into pressure from regulators, customers and investors, said the report.
But on the flip side, banks that take the lead into sustainable endeavours could enjoy a better reputation, higher valuations and even better financial performance.
Accenture found a direct link between ESG and financial performance, with an EBITDA margin potential increase of up to 15% in relevant industries through large-scale adoption of circular economy business models.
The trend of integrating sustainable practices in banks’ activities has already taken hold, especially in the investing sector. Nearly a third of the total $51.4 trillion assets under management in the US are managed with ESG considerations. Lending is starting to display a similar pattern, with sustainability-linked loans surging from $5 billion in 2017 to $120 billion in 2020.
So what type of sustainable lending options do banks have at hand? The report outlined a few products and instruments that banks can adopt:
Banks can also leverage their investments in automating and speeding up credit processing (e.g. data-driven credit, digital lending, operations automation) as they incorporate ESG considerations into lending decisions. The graphic below shows how banks can integrate ESG lending into their workflow by focusing on three key areas:
- Transform their lending value chain: prioritizing the implementation of an operating model that has zero-net impact and enables banks to make ESG-coherent lending decisions.
- Reskill their lending practice: training and upskilling programs around sustainable lending value propositions and ESG criteria.
- Set up ESG data platforms: building data platforms, creating ESG scoring models and tapping into third-party data to link ESG considerations to credit policies and, ultimately, product offerings.
Transform the lending value chain
Incorporating ESG criteria into the end-to-end lending process is essential to the shift towards sustainable lending, as manually integrating ESG data into their credit assessment would prove to be inefficient and cost prohibitive at scale, the report said.
In this process, core components of the lending value chain, such as product specifications, documentation and collateral materials would need to change in order to reflect ESG principles.
Here’s a look at how banks can implement a redesign of each component of the lending value chain:
Setting up the ESG data platform
Most banks use traditional credit risk models and don’t have the data capabilities to power sustainable lending risk models. This data problem is one of the biggest challenges in the industry’s road to sustainability, as the FSOC also highlighted in its report last year.
Moreover, there is also the issue of inconsistencies among ESG methodologies. For example, an MIT study found that the correlation between different agencies’ ESG ratings was 0.61 on average, versus a 0.99 correlation coefficient recorded at credit rating agencies like Moody’s and S&P.
The illustration below reveals five key areas that outline the inconsistencies and complexities banks currently face when dealing with ESG data.