Integrating environmental, social and governance factors in lending processes

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Integrating environmental, social and governance factors in lending processes

New EBA loan origination and monitoring guidelines: implications for banks

On 29 May 2020 the EBA published its final report on the Guidelines on Loan Origination and Monitoring. These guidelines will apply from 30 June 2021. As a result, the urge to consider Environmental, Social, and Governance (ESG) factors and associated risks in the lending process of banks has further increased.

ESG in lending processes

The Guidelines on Loan Origination and Monitoring state ESG factors and associated risks should be integrated in lending processes, i.e. in the credit risk appetite and risk management policies, credit risk policies and procedures (4.3.5 par 56). This shows that sustainability is becoming an important factor in the core of banking operations. Integrating ESG factors into key business practices will support the transition of the financial sector towards a more purpose driven industry andwill contribute to a more sustainable economy. On top of that, a strategic ESG focus will also benefits the banks themselves, read our article Three reasons to keep focusing on environmental, social and governance factors.

ESG factors and risks

Moreover, ESG risks are material and can no longer be ignored by financial institutions. Climate risks such as the risks of extreme droughts or floods (physical risks) and transition risks associated with a transition towards a carbon-neutral economy will affect the risk of borrowers and should therefore be comprehended by financial institutions. 

For banks, incorporating ESG factors and ESG risks into their lending business impacts the entire lending process, from sales to credit origination, to monitoring, and post servicing. ESG factors and risks can be incorporated into each of the steps of the lending process.

Implications and challenges

Incorporating ESG factors and risks into the lending process introduces new challenges for banks.

  • Strategic challenges

    Banks need to reconsider their strategy and business model in order to be able to include the increased focus on ESG in their strategy and KPIs. Subsequently, the updated strategy should be cascaded further down the organisation and be integrated in the risk appetite framework and the key risk indicators. For instance, banks should define whether there is a focus on excluding specific potential clients or a focus on the impact the bank can make by supporting borrowers to become more sustainable.

  • Data challenges

    Banks require a different type of sector and borrower information, in order to be able to: (i) quantify ESG risk and (ii) monitor the client’s activity around sustainable projects or activities. 
    Understanding which data is required and collecting the relevant data can be challenging. Banks should consider alternative ways to collect the relevant data. An option can be to collaborate with other institutions or to consider new data sources. An example of a new data source relevant for ESG factors can be news feeds (see separate box on SenseNexus).In order to scale ESG integration, Deloitte has also developed the ESG Data Lab. Data lab is the technology and advisory solution for a comprehensive, robust, transparent and adaptable implementation of ESG information.

  • Modelling challenges

    Integrating ESG risks in all relevant stages of the lending cycle and in collateral valuations introduces modelling challenges. These are new modelling requirements that have no common market practice modelling approach yet. Hence they pose significant challenges on how to model these ESG risks in the most appropriate way. It is key that these ESG risks, for example climate risks, are well integrated within the existing credit risk management frameworks. The impact of climate risks on credit risk estimates of borrowers needs to be quantified. It is a challenge that the time horizon for climate risk is typically long term. Furthermore, the backward looking character of conventional credit models for regulatory capital might not be suitable for measuring the future impact of climate risk. IFRS9 models can be a starting point, and quantifying the link between macro-economic variables and climate risk is key in quantifying climate risks. 

Climate change and society’s general response to it have increased the relevance of ESG factors and associated risks for financial institutions. It is essential that banks are able to measure and monitor the ESG risks in order to incorporate them into their strategy and purpose. This creates challenges for the banking sector, but also opportunities to become more purpose led and to support the move towards a carbon-neutral economy. 

Our advice is to first develop a thorough understanding of the ESG risks and ambitions on the current portfolio by engaging with borrowers on ESG topics, and clearly define your strategic ambitions. As a next step an integrated approach is required to be able to understand ESG factors and properly quantify ESG risks in the banks’ lending portfolios.

SenseNexus : A world of information in a comprehensive dashboard
SenseNexus is an online dashboard that provides you with ESG intelligence on your organisation and key clients or counterparties. Every day it reads and interprets over 1 million public news articles from 750.000+ websites across 12 languages. It uses a semantic engine to identify ESG risks and opportunities, and link those to the applicable companies and locations. This allows you to benchmark companies, identify trends and dive deeper into specific events by looking at the original sources of the information.

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