Policymakers, investors, banks and the public have spent a significant amount of time over the last few years talking about ESG risks. That effort has though been unevenly focused: work to address the ‘E’ (Environmental) and, to a lesser extent, ‘G’ (Governance) has somewhat overshadowed the ‘S’ (Social). Policymakers, particularly in the EU, have been clear that all elements of ESG risks are on their radar, and several recent high-profile events have provided a reminder of how social risks can have a reputational and financial impact on banks and their counterparties. Banks should start the process of more-fully integrating social risk alongside environmental and governance considerations into their business strategy, risk management and governance structures.
Why should banks think about this now?
Evolving societal expectations, and the potential financial consequences for banks and their counterparties, will act as a catalyst for increasing supervisory attention. The EBA’s action plan on sustainable finance interprets ‘sustainability’ in a broad sense – covering all ESG factors. This perspective has been continued through to the deliverables in the EBA’s workplan, including the Discussion Paper on the inclusion of ESG risks in the SREP and the Consultation on the inclusion of ESG risks in the Pillar 3 framework. The discussion paper on ESG risks notes that there have been several initiatives to define ESG factors, but that a common definition is lacking. However, the EBA finds that ESG frameworks usually capture social factors “related to the rights, well-being and interests of people and communities”, including workforce, community, and supply chain.
Social risks can emerge from societal concerns. There are also inter-dependencies between the different ESG factors. For example, climate change can exacerbate existing systems of inequality causing a disproportionately large loss of income for disadvantaged groups. And robust governance practices underpin good environmental and social practices.
The negative reaction variously by the public, policymakers and markets to the football Super League proposal and to news stories about working conditions at a prominent clothing manufacturer, are recent examples of the heightened social sensitivity to social and governance issues.
In contrast to climate-related risks (particularly transition risks), which are generally (although not exclusively) understood to materialise over longer time horizons, social risks, such as the negative consequences of poor social practices, often materialise almost instantaneously. Social media has the potential to amplify negative consequences quickly. And consumers and investors are prepared to ‘vote with their feet’. Deloitte research published earlier this month found that ethical considerations are a key consideration for consumers, and consumers are increasingly willing to stop purchasing certain brands or products due to ethical concerns.
Banks will be required to make qualitative disclosures about their ESG risks by mid-2022, and quantitative disclosure requirements will follow. By 2022, banks will need to qualitatively disclose how social – and governance – risks are taken into account in their governance arrangements, business model and strategy, and risk management.
Ratings agencies include ESG factors in their credit ratings. Poor practices will lead to ratings downgrades for banks or their counterparties, potentially leading to increased funding costs. A fall in share price associated with ESG factors would also affect the cost of equity. And ESG factors could affect the probability of default of banks’ counterparties, for example, through decreases in revenues where a counterparty’s practices do not align with society’s evolving expectations around social and governance factors, or through increased costs due to fines, regulatory penalties or litigation.
What should banks be doing?
The EBA’s proposed qualitative disclosure requirements demonstrate that the supervisory principles for social risks are broadly similar to those for environmental and governance risks. Banks’ business strategies must integrate social risks, and set short-, medium- and long-term targets and limits. Social risks should be integrated fully into banks’ risk management framework – which includes setting a risk appetite, identifying and monitoring social risks, and assessing and managing the impact of social risks on their balance sheet through traditional prudential risk categories. Banks will also need to explain how they use tools such as scenario analysis to determine risks to their solvency and liquidity risk profile posed by social factors. Governance structures must support risk management of social risks, and be effective in cascading throughout the organisation the bank’s consideration of social risk in its strategy and risk appetite.
Metrics, models and data will be a challenge to develop, as is the case for climate risk, and methodologies are still evolving for the quantification of social risks. However, banks can still make a start on integrating social risks into their activities and operations. For example:
- Banks should focus their initial efforts on ensuring that the Board has sufficient understanding of social risks, and on setting the risk appetite, which will then underpin how social risks are incorporated into the bank’s business model and strategy.
- Initiatives to gather data from customers and counterparties to inform the assessment of climate risks can be extended to capture data to inform the social risk (and governance risk) assessment.
- Changes being made to IT systems and processes can be extended to build the flexibility to develop social risk capabilities at a later date.
Banks that tackle ESG in a complete and joined-up way will be best placed to adapt to the changing business environment, in which ESG considerations play an important role in the success or failure of banks and their counterparties. There are likely to be synergies with investments already being made for climate risk, and by tackling all components of ESG together banks will reduce the risk of advances in the management of one factor being made to the detriment of another.