Environmental and social risk management in banks enables banks to intentionally avoid financing business activities that cause human rights violation, undermine biodiversity and cultural heritage of communities. It is not good business for banks to support businesses whose activities result in environmental pollution, human safety and security concerns. Environmental and social risk management (ESRM) may also mean supporting clients and investments whose net impact contributes to positive environmental and social outcomes
Environmental, Social and Governance (ESG) investing is the recognition that successful enterprises have a diverse workforce, work through progressive corporate governance principles, and care about people and the environment. The main lesson from ESG guiding principles is that companies committed to sustainability are positioned for growth and success. Before ESG became a lens through which the viability of an enterprise was assessed, environmental degradation and human rights violation was the acceptable consequence of big firm capitalism of extraction. ESG’s rising prominence demonstrates that such business outcomes are indicative of poor corporate leadership.
Environmental and social risk management in banks serves as a criterion for ESG assessment. For banks ESRM underscores the risks banks must contend with including credit, equity, business, commodity price, compliance and reputational risks. By definition a credit risk is the possibility that over the course of doing business, a borrower may diminish its capacity to pay the amount due to a lender. Banks may issue credit with equity as collateral or even acquire equity using its investable liquid assets.
Business risks are factors that undermine the profitability of an entity, meaning both equity and credit risks contribute to business risk. Agricultural, energy and industrial commodities held by banks may expose financial institutions banks to commodities risk with the fluctuations of prices as a result of changes in demand and supply. Other types of risks which are important to manage include compliance risks, which are risks incurred as a result of failing to comply with industry regulations. Non-compliance exposes banks to legal penalties, reputational damage and financial loss. Reputational risks are when a bank’s brand is damaged as a result of a bad reputation.
A proper ESRM assessment works to highlight investments or clients whose business activities could be likely to result in ESG violations. Such client violations often expose banks to credit, equity, business, commodity, compliance and reputational risks. ESG violations often result in public outcry which is often in the form of consumers boycotting products of the implicated companies, production cuts emerging from exhaustion of natural resources and product liability claims. The aforementioned consequences of ESG violations undermine the value of a stock. Changes in stock price means diminished returns from the equity investments and may pose a credit, equity and business risk, especially in situations in which equity serves as collateral. Ethical scandals, public outcry and liability claims significantly tarnish the reputation of a bank. Banks can suffer reputational risks or public loss of confidence by dealing with or supporting greenwashing businesses.
With the push for renewable energy, the demand for commodities such as oil and gas are set to diminish over the years as a result of ESG policies in major economies of the world. A comprehensive environmental and social risk management methodology will deter banks away from holding or investing in energy commodities or products that are produced by use of fossil fuels. Such commodities and products are in the near future expected to contend with price shocks, regulatory compliance challenges and reputational risks.
With an increasingly dynamic and complex business context, the future of risk management in banking leverages artificial intelligence (AI) and machine learning (ML) tools. Presently banks use big data and analytics to quantify and optimise their risk exposure. Tools like AMPLYFI’s DeepInsight uses machine learning and artificial intelligence to analyse unstructured data in the deep web and surface early warning signals or trends of events, for example those that are likely to expose banks to environmental and social risks.
Tools such as DeepInsight can support environmental and social risk management in banks as platforms for appraising investment opportunities or borrowers risk factors. The tool reveals adverse media mentions under categories including tax evasion, fraud, bribery and corruption. Financial institutions can also leverage DeepInsight to discover entities connected to a business of interest and investigate further if such connections could serve as pathways to risk factors.
For more information on how AMPLYFI can support your environmental and social risk management, book a free, no-obligation consultation with one of our experts.