ESG Risk: A new paradigm for Risk management

In this blog post, we explore how the scope of risk management should evolve to contribute to achieving sustainability for banks.

Over the last few decades, we have witnessed a spectacular evolution in the practice of risk management in banks. This includes significant developments related to financial risk management and the assessment of climate change implications to financial risks. 

To date, the scope of risk quantification in banking has been limited to assess the change in value of internal assets (in both the trading and banking books). This is because the traditional assumption is that the value of the bank and its future expected profitability depends on the value of its internal assets.

However, is this assumption completely true when we consider sustainability?

Three key sustainability themes

Three key themes are emerging as part of the new considerations related to sustainability.

  1. Sustainability and profitability are both required businesses that can survive and thrive in the long-run are only those that are sustainable.

  2. Businesses operate in one interconnected ecosystem internal and external assets (i.e. environment, society, governance (ESG)) are both directly (and indirectly) correlated to business value and performance, therefore protecting (and developing) external assets is just as important as internal assets.

  3. Banks have committed to a key role in achieving a sustainable future – many banks have now joined the Principle of Responsible Lending movement of change, a framework for banks to align their strategy and practice with the United Nations sustainability objectives and make a positive contribution to people and the planet.

These key themes create a new scenario for the banking ecosystem. Both stakeholders and shareholders are increasingly expecting banks to become part of the ‘green’ solution, transforming their purpose, strategy and value drivers.  

A new paradigm for risk management

As banks are expected to transform their business to become sustainable and also facilitate the green transition of their clients, they will have to set, monitor and manage new objectives around sustainability.

Banks are now required to achieve targets related to external assets. This requires them to understand the impacts of bank operations on external assets. This is because they are becoming as important as internal assets to achieve long-term performance and sustainability targets.

This requires banks to evolve the scope of risk management to include the quantification of risks related to external assets, supporting metrics, measurements and analytics that will drive and control the required transformation. Risk management should identify those risks that have an impact on the achievement of sustainability targets related to the Environmental Social Governance (ESG) factors (i.e. ‘ESG risks’), measure and report them. 

This is a new paradigm for banking risk management, which requires rethinking the entire risk framework, governance, data, metrics and reporting.

New measures of risk will have to be developed to assess ‘ESG risk’, which is now being addressed by scenarios and stress testing. Banks could measure ‘ESG risk’ as the potential change in value of those external assets that are relevant to the business, which are dependent on the changes in the bank balance sheet composition, internal business drivers and operations. 

Risk frameworks, governance and accountabilities should be aligned to consider ESG risks, enabling better management and strategic decision making.

A recent example is the consideration of biodiversity and its importance to business sustainability. A few banks have already started to include natural capital risk in their business and investment decision process and are pioneering metrics and methodologies to assess this. The taskforce on Nature-related Financial Disclosures (TNFD) has been launched to develop a risk management and disclosure framework for nature-related risks. Further action is also being taken by the Science Based Targets Network to develop a framework for companies to set science-based targets for natural capital.

Parting thoughts

Risk management in banks has evolved. It provides a better understanding of the risks related to the bank’s internal assets which is critical to the achievement of strategic objectives.

However, there is now a case for risk management to take a more holistic approach in assessing the impacts and risks related to those external assets relevant to the success of the bank. Such information is of vital importance to drive both sustainable and profitable business decisions.

 

ESG Risk: A new paradigm for Risk management

22.06.22

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