The ESG, banking and technology triangle
"The social responsibility of business is to increase its profits." The statement made in 1970 by one of the most respected economists of the 20th century, Milton Friedman, is now surely outdated and outmoded.
Nowadays, it is objectively more accurate to state that one of the means for a company to achieve its financial goals, namely profit, is by committing to ESG (Environmental, Social and Governance) principles. These principles have also shown to be a business opportunity for companies and, consequently, for economies in general.
As banking is one of the biggest - and safest - vectors for boosting an economy, the banking sector is also key to ensuring our sustainability at a global level and to the commitment made by the Member States in the 2015 Paris Agreement (on climate change).
As a starting point, it should be stressed that financial institutions - just like non-financial ones - have included in their agendas the commitment to sustainable development goals. And this is not the only role to be played by banks when it comes to aligning with these goals.
Banking institutions, especially through credit granted to economic agents, are the main vehicle for implementing and boosting new projects in the economy. Hence, it is now also necessary to include ESG evaluation criteria in their internal investment and financing analysis processes.
Regulatory bodies' own legal guidelines have already acknowledged this role by determining that risk analysis should incorporate sustainability criteria, specifically the physical and transition risk factors that incorporate climate risk.
These "new" factors also end up impacting the main financial and non-financial risks (credit risk, market risk, operational risk, etc.). Example? If a bank is already assigning benefits to a lower-risk financing compared to a higher-risk one, it also makes sense that gauging the ecological and social footprint of a particular project impacts the fees or financial margins that this bank is willing to take in the process of financing that project.
The EBA (European Banking Authority) published, in January 2022, a regulation making it mandatory to publish a set of so-called Pillar 3 disclosures on ESG risks. The aim is to promote transparency as to the impact of environmental, social and governance risks on the already known risks that traditionally affect banks' balance sheets. This new standard also explicitly establishes the need to manage and mitigate these risks and to assess the exposures in line with the Paris Agreement, which makes it necessary to include ESG criteria in the business models, strategy and governance of the banks themselves.
In addition to the IASB (International Accounting Standards Board), the entity that sets the IFRS Accounting Standards, the ISSB (International Sustainability Standards Board) was recently created with the task of setting the IFRS Sustainability Disclosure Standards. The result is there for all to see! At the end of March, two draft standards were published: IFRS S1 on the general requirements for disclosure of sustainability-related financial information and IFRS S2 on the identification, measurement and disclosure of exposures to climate-related risks and opportunities.
In line with all these initiatives, one of the main challenges financial institutions face today is related to the new dimension of data to consider when analysing the quality of their assets, investment projects, common banking processes and margins. From now on, it becomes necessary to include ESG ratings in their risk analysis, ESG evidence from companies and projects (e.g., CO2 emissions, social responsibility, governance suitability), criteria for green fund management and access to a sustainable capital market. In fact, the latter factor has served as a vehicle for the transition to a greener economy.
Again, by turning to sustained digital transformation, it becomes essential to consider the operational needs and costs related to the analysis and processing of this new dimension of data. Strictly speaking, this new dimension should mean that banks will have to outline more or better business processes, namely processes for analysing customer and project credit risk, processes for marketing products and reporting internal information or information to the regulator.
All these (necessary) changes may require the transformation of some of the currently existing processes, and these changes may be more efficiently implemented with the use of technology, data reading, interpretation, analysis and transformation processes, automation of procedures and digitisation.
Just as banking, due to its impact on the economy, plays a crucial role in the concern for a more sustainable world, technology also proves to be indispensable for an efficient implementation of the ESG culture.
