Banking, climate risk and sustainable finance: from awareness to action

Over the last few years, the world economy has invested significantly in climate change awareness. The time has come for the world to take concrete steps from awareness to action. The same applies to the financial services industry with banking in the forefront. Although the national and supranational supervisors have taken the first steps in developing a path for the sector, the banks will need to expedite the implementation of comprehensive climate risk and sustainable finance strategies. Regardless of being a pioneer or a late adopter, the challenges remain broadly the same.

Data fragmentation. In the effort to translate climate risk into financial risk, comply with reporting and disclosures and develop a suitable risk mitigation plan, the banks are challenged by the availability and quality of data. (i) Borrowers of different sizes and maturity profiles do not always provide to the bank uniform data points regarding their environmental profile. (ii) Data vendors do not produce similar quality and quantity of data across geographies and segments of the economy. (iii) Although taxonomy is defined at a European legislation level, there is still no pan-European initiative to develop and deploy pan-European sustainability data sources. The banks that register the most progress are trying to close the gap by: (a) identifying and mapping the variety of public and sources of sustainability data, (b) collecting data from borrowers while utilizing a customer segmentation approach and making up for data gaps with the development of statistical methods to transpose data findings across sectors or corporate sizes etc. and (c) developing data proxies where there is no availability of credible data.

Internal stakeholder engagement. Action without education is fruitless. In the last years, most banks have launched internal campaigns to create awareness and incubate ideas for action. However, the time has come for banks to act more decisively with an internal structure that can enable service. Best practices include: (i) the development of the role of the Chief Sustainability Officer (CSO) and the respective department, reporting directly to the CEO and the board; (ii) the technical education of the management and supervisory boards to be able to assess, challenge and promote climate risk management and sustainable finance strategy developed by the CSO; (iii) the assignment of sustainability targets to the bank by department but also by employee to boost department and personal accountability over the deployment of the strategy; (iv) the development of bank-wide education tailored for the needs of each department and level of professionals to enable human resources across the bank to implement the strategy; (v) the up-skilling and equipment of the internal audit department to be able to monitor quantity and quality of progress and appropriately report such to the members of the board.

External stakeholder education. If you don’t teach your clients, competition will. Although it may seem like a big investment, unless the bank educates its clients, they will not be able to provide dependable sustainability data and in time they will not be able to transform their own business strategy and remain “bankable”. On the contrary, corporates and individuals will be attracted to those banks which are willing to educate them on how to retain and develop access to sustainable finance. Educating the borrowers is an investment directly linked to the retention and development of one’s market share. The successful development of an education plan requires deep sectorial expertise to be able to understand the economic conditions and transformational challenges of each part of the economy in order to better understand how the bank should develop suitable products and underwriting policies. This is not very different from what the banks have traditionally done with their borrowers on how to successfully manage credit risk regulation over the years. The challenges with climate risk and sustainable finance are that (i) the time horizon to learn and respond is a lot shorter and it requires an intensive effort from the banks compared to the “trial and error” learning method that was utilized in the past, (ii) every sector of the economy has different challenges and needs and requires a specialized educational program to understand how to design for itself a sustainable strategy and (iii) the bank needs to align the educational program with a sector approach from the risk department that is linked to a sector approach from the underwriting department.

In summary, the era of the general awareness on climate risk and sustainable finance has passed. The banking regulators and supervisors are taking concrete steps to challenge the banks on their own obligations of a net zero strategy. However, the biggest risk for a bank is not the lack of its ability to respond to the regulator’s requirements. The biggest risk for a bank adopting a passive approach to the change is market share erosion.