How is credit risk affected by ESG factors?

There is growing interest among banks in production systems compatible with environmental protection, greater social balance, and sound governance practices. Lenders are being encouraged to pursue similar objectives by increasingly widespread regulations and the growing awareness of investors and customers. Openness toward environmental, social, and corporate governance (ESG) requirements is all the more important in a trust-based business such as financial intermediation, and the ability to respond to changing public attitudes and sensibilities can become a powerful driver of success, as confirmed by the high growth rates seen by “sustainable” mutual funds and other forms of responsible investments.

While the banking system is aware of the strategic importance of ESG issues, their practical introduction into lending processes (and in the monitoring tools that guide management actions) is still extremely heterogeneous and fragmented.

A new white paper issued by CRIF (incorporating recent work by the Italian Association of Financial Industry Risk Managers, AIFIRM) looks at the risk management processes of banks and, after defining ESG factors and how they interact with traditional banking risks, discusses how risk governance can be enhanced to incorporate ESG metrics, starting with those dealing with climate-related and environmental risks. It also focuses on loan origination and monitoring processes, showing how ESG factors can be incorporated into lending strategies, loan pricing, and collateral selection.

The research examines the possible relationship between ESG variables and credit risk. One case study is presented concerning the introduction of ESG variables (mostly environmental) into bank rating processes. Even if the results are incomplete and preliminary, they suggest that there is a potentially positive and statistically significant impact of ESG factors on the creditworthiness of bank borrowers.