Note available here.
Banks worldwide are grappling with the problem of integrating Environmental, Social and Governance (ESG) issues into their businesses. ESG provides a new criterion for judging exposures, activities and ways of working over and above the traditional basis for decision-making in banks, i.e., risk adjusted financial returns. The two are linked to the extent that ESG issues create financial vulnerabilities, for example, through climate transition risk or reputational costs. But much of the ESG impact of business activities consists of externalities, costs imposed on others that do not contribute to the firm’s own bottom line.
The preferences of investors and regulators are pushing all firms that raise capital and obey regulatory rules to take account of ESG in making their decisions. Banks are at the centre of this trend both because they depend on markets on a large scale to finance their operations and because they are tightly overseen by international regulators who are gearing up to include ESG factors in their reporting, vulnerability assessments and supervision processes.
What should a bank do to develop its ESG strategy? There are four key elements that banks must put in place. The first element is to tackle the data problem. The last three decades have witnessed a revolution in the use of data-driven, quantitative modelling within banks, to start with, inside their risk functions, but, increasingly, throughout banks’ business activities. ESG is a major challenge to banks in that it requires new ways of recording and analysing impact and then feeding information into appropriate business decision-making.
The three other elements are equally important: (i) analysing vulnerability, (ii) positioning the institution to be compliant with emerging regulations and (iii) instituting transparent and convincing reporting to the market, senior managers and regulators. But all of these rely on a resolution of the basic problem of collecting high quality data.
This note discusses the data strategy that banks should follow in implementing their broader ESG policies. Future notes will examine the three other aspects.
