After major improvements in bank governance following the global financial crisis (GFC), Atlanticomnium’s Romain Miginiac suggests banks are likely to play an increasingly active role in the environmental transition.

More than a decade on from the GFC and the subsequent overhaul of banking regulation, banks’ corporate governance (G) profiles – the big ESG issue for banks pre-GFC – have significantly improved and are now a positive driver for European bank credit investors. As we enter a new decade and phase of regulation, a progression from G to environmental (E) is occurring, with climate risk the new area of focus. Although climate risk is material for the European banking sector, regulation will continue to act as a positive catalyst for banks’ ESG profiles, building on a positive track record of transforming the banking sector post-GFC. Banking-led initiatives are also gaining momentum and given their dominant role in financing the European economy, banks are likely to play an increasingly active role in the environmental transition.

The G issue among banks

Without a doubt, G has dominated banks’ ESG and credit profiles since the GFC. The G issue among European and global banks has led to outsized value destruction in the sector, be it from elevated losses during the GFC or elevated misconduct costs over the past decade. Ahead of the GFC, a combination of poor risk oversight, excessive risk taking and a focus on short-term profits, combined with loose regulation, led to outsized vulnerability of the European banking sector to external shocks. As the GFC unravelled, banks were unable to absorb large losses on loans and securities, leading to failures and bailouts of systemically important banks. Instead of dampening the crisis, banks exacerbated the impact, resulting in one of the most severe contractions seen in history. Post-GFC, past behaviour has led to significant misconduct costs that have weighed on the profitability of the sector for years. European banks have recorded misconduct costs well in excess of EUR 100 billion in since 2008¹ , reflecting a number of legacy issues (US sub-prime mortgages, market manipulation, etc).

Regulation – the catalyst for positive G changes

Perhaps the biggest trend in bank governance over the past decade has been regulation. In the aftermath of the GFC, regulators were given the arduous task of overhauling banking regulation to ensure that another GFC would not occur. In particular, increasing the resilience of the banking sector to external shocks and ensuring banks could weather a stress scenario – without the need for public money.

Basel III is the outcome of years of strengthened regulation, implemented in most jurisdictions around the world, including in Europe in 2013 via the Capital Requirements Regulation and Directive (CRR / CRD). The focus has been on addressing the key shortcomings of previous regulatory regimes and banks’ inability to weather economic shocks. Key elements include increasing capital and liquidity requirements, strengthening risk management practices and regulatory oversight, and finally, improving disclosures and transparency. Both the quantum of capital that has been raised and improved risk management and oversight have been essential in transforming the sector. Banks have been forced to de-risk their lending and trading operations, otherwise facing elevated capital needs from new regulations, paving the way for banks to shed higher risk assets and downsize riskier capital markets operations. Improved disclosures and transparency has also allowed better insight for investors into the potential risk factors among banks.

As a result of tougher regulation, banks’ governance profiles have improved significantly. G has become a positive driver of banks’ credit profiles, and rendered the sector one of the most resilient. The current Covid-19 crisis is a testament to this improvement, where the European banking sector has been able to absorb a deep recession while continuing to support clients and the economy. Banks now act as buffer for economic shocks, not as amplifiers. Litigation costs have also been declining (peaking in 2013 / 2014), as a result of improved corporate governance practices. There remain some areas of improvement, reflected in recent fines for money laundering issues. However, the trend has been one of strong improvement, and now the G is a positive for investors holding banks’ bonds.

From G to E – where is the climate risk for banks?

For credit investors, the focus in the past decade has been on G to navigate the post-GFC reconstruction of the banking system. Although regulation continues to advance and will undoubtably lead to further strengthening of banking fundamentals (Basel IV on the horizon), banks’ G is now nearing end-state ambitions. Therefore, now that the banking sector has been “fixed”, the regulatory focus can shift to the E – environmental issues. While banks’ own operations carry limited implications for climate risk, the indirect impact through banks’ lending books has larger ramifications. Climate risk threatens banks both through physical risk (impact from climate events) and transition risk (risks linked to the transition towards a greener economy, such as stranded assets). An example of physical risk would be loan losses from a project that has defaulted due to physical damage from weather events (hurricanes, fires, etc). An example of transition risk would be high loan losses from defaults of companies in the coal sector in case of an abrupt shift to greener energy, leading to a drop in demand. There are two areas of potential vulnerability for banks’ loan books, corporate lending exposures to “at-risk” sectors (energy, transportation, etc) and lending exposures in areas exposed to climate change (mortgage lending in areas with flooding risk, etc). While banks’ exposure to climate risk in lending books varies on a bank-by-bank basis, overall this is a material risk that needs to be addressed, with an otherwise potentially large negative impact for the sector. Furthermore, as banks remain the primary source of financing for European non-financial corporations, the role of banks in the environmental transition is pivotal.

Change is coming and momentum is strong

As previously mentioned, regulators’ track record in rebuilding the European banking sector has been very successful, reflected in resilience underpinned by strong G and rock solid fundamentals. The time has now come for the regulatory focus to shift from G to E, as the G is no longer (or less) problematic (although will remain a key part of the regulatory agenda), and banks are now in shape to face the climate challenge of the coming decades. Regulatory pressure is mounting on banks to tackle environmental risk. The regulatory agenda follows the political agenda in terms of the focus on climate issues and sustainable growth, as reflected in the green focus in the European recovery fund and the longer-term European Union (EU) budget, where at least 30% is earmarked for environmental projects. Furthermore, Christine Lagarde, president of the European Central Bank (ECB), has repeatedly stated that climate change is a priority for the central bank, resulting in both monetary policy and banking supervision of European banks.

While regulatory efforts around climate risk are widespread and span a broad range of topics, from a bondholder’s perspective, the key efforts are around disclosures, action plans and capital allocation. Firstly, different workstreams have been set up to increase transparency around the carbon intensity of banks’ lending books and associated climate risk. This is designed to tackle both increased disclosure, but also consistency and comparability of disclosures of data across banks. With better visibility on risks and consistent indicators, investors will have better insight into individual banks’ climate risk. Secondly, banks have been asked to submit actions plans on how they plan to address climate risk for their operations (including loan books). For example, the UK’s Prudential Regulation Authority (PRA) has required UK banks to submit such plans by the end of 2021. Lastly, and perhaps most importantly, is the inclusion of climate risk in capital allocation decisions. The ECB and the UK’s PRA will be including climate risk in future stress testing – a game changer. As stress testing feeds directly into banks’ capital planning, penalising banks with significant climate risk will ultimately drive a shift away from lending to carbon intensive industries towards environmentally friendly industries. Further pressure from banks on their customer base to take action and reduce their climate risk exposure is another expected outcome. This is already reflected in banks’ lending behaviour. This is not only done through commitments to reduce lending to the most polluting industries, but also by steering the new flow of credit. For example, new green lending products have emerged, with discounts on margins for borrowers to fund projects with positive environmental impacts. For example, several European banks offer discounted rates to mortgage borrowers financing high energy efficiency properties.

Other industry initiatives have also emerged. In 2018, as part of the United Nations Framework Convention on Climate Change (COP24), several European banks partnered to create a methodology to measure the alignment of their corporate lending portfolios towards the Paris Climate Agreement objectives. The Paris Alignment Capital Transition Assessment (PACTA) methodology takes a granular sector-by-sector approach with standardised results and reporting. Widespread adoption of such initiatives will ensure better disclosure of climate-related risks, as well as increased ability to benchmark banks against stated objectives.

In conclusion, E is likely to be the focus of investors and regulators in the coming decade regarding banks’ ESG profiles. With banks’ credit profiles now more robust, regulators can now focus on ensuring that the sector will play a pivotal role in financing the green economy. Regulatory pressure is shifting to climate risk in their lending operations and climate resilience of the banking sector. The track record of regulators in fixing the European banking sector after the GFC underpins our view that the E profile of banks is set to improve drastically. This will be driven by better disclosure, gradual reductions of lending to carbon heavy sectors, as well as steering capital towards the green economy. This has already started, and will be accelerated by regulatory pressure.