Recent banking failures have put responsible investment in the financial spotlight. In short, the US banking crisis was driven by unique factors including large amounts of uninsured deposits and losses on banks’ investments in government bonds relative to the size of their capital base.
What caused the US banking crisis and what could come next?
This was ultimately a governance issue – a major part of the environmental, social and governance (ESG) equation.
ESG is often misunderstood as a catch-all term for being environmentally friendly. That’s part of it, but it’s also about being a good corporate citizen and how that might affect long-term financial performance.
Just as you’d use different financial metrics to value an asset-heavy airline stock and an online tech company, ESG isn’t one-size-fits all. Different sectors carry different risks – in some cases the environmental impact might be a key strategic risk, while in others quality control matters most.
For banks, governance is incredibly important.
What is governance and why is it important to banks?
Governance includes everything that goes into running a business – from how to set CEO pay to the policies that dictate employee behaviours.
The fall of Silicon Valley Bank (SVB) can be clearly traced to governance failures – from its months long absence of a Chief Risk Officer in 2022 to the Federal Reserve’s warning of inadequate risk controls in the bank in 2020.
That warning played out with flourish last month, as overlooked interest rate risk ultimately brought the bank to its knees.
For larger banks, particularly in Europe where capitalisation rules are tighter, some of that risk management has been regulated into their operations. For smaller banks, like the US regional banking sector, risk management is an organisational decision, and one that investors need to keep a close eye on.
With that in mind, here’s a look at some of the key governance risks that apply specifically to banks.
This article isn’t personal advice. If you’re not sure if an investment is right for you, seek advice. Investments can fall as well as rise in value so you could get back less than you invest.
Considering ESG issues can form a part of your investment analysis and decision-making process, but it shouldn’t be a replacement for fundamental financial research.
Company culture threatens to derail banks
Business ethics risks loom large for the banking sector. That’s because there’s more potential for things like bribery, tax evasion and market manipulation. Mistakes in this category are the most common, and they also tend to be the most severe.
Take Wells Fargo, for example. Between 2002 and 2016, the bank opened millions of accounts in customers’ names without their knowledge. The practice was widespread among employees thanks to impossible-to-meet sales targets and a growth-at-any-cost culture.
On top of $3bn in criminal charges and the reputational damage that came along with the highly publicised ordeal, Wells Fargo is still constrained by a 2018 asset cap set by the Federal Reserve in response to its poor risk management. Some estimate that this has cost the bank billions in profit over the past five years.
Banks are less likely to experience ethical missteps like this with strong policies in place to discourage this kind of conduct. This usually starts at the top, with board-level responsibility for business ethics issues that feeds into a solid code of conduct and regular training on expected behaviour.
Commitment to investigating and correcting any breaches should be disclosed, with a comprehensive whistleblowing programme in place and proactively communicated to employees.
Listen to our latest podcast – What’s next for the banking sector in 2023?
Product pitfalls
Banking services are crucial to just about every person in the developed world. From having a fair shot at a loan to understanding the risks and charges associated with different types of accounts. Banks’ duty to consumers is important in day-to-day operations. Regulators keep a close eye on these issues, and around a quarter of banks are currently involved in a significant controversy.
The risks in this area vary depending on location. For example, banks operating in the US, are more exposed than others because consumer lawsuits are more common.
Banks with a large retail customer base are also more at-risk because their customers are more vulnerable to predatory lending and misleading advertising. Those with large corporate arms aren’t immune though. While these customers might not sue over inappropriate product offerings, they will take their business elsewhere if they’re not satisfied. All of this can impact the share price.
Product governance concerns are starting to materialise in the buy-now-pay-later (BNPL) space. It’s an area that grew quickly throughout the pandemic as people looked to spread the cost of their purchases without added interest.
But regulators are starting to sniff around to see whether these companies are doing enough to protect consumers from the risks that come with taking on this type of debt. If they’re found to be unfairly preying on consumers, we might see regulations and penalties eat into the viability of these businesses.
To avoid these risks, a bank should have a visible policy commitment to responsible product offerings. That means regular monitoring of the impact and risks of current products and services and regular training on responsible marketing.
Including a thorough impact and risk assessment analysis into the development of new products is also an important step in lowering these risks.
Companies that clearly disclose these policies as well as their product and service quality ratings are in a stronger position to avoid product governance pitfalls.
The cost of a ‘sustainable’ label
Business ethics and product governance have long been considered key banking risks, but the risk of greenwashing is a much more novel concern.
Climate change is increasingly important for both investors and consumers these days. Investors might worry as we shift to cleaner energy that exposure to carbon-intensive industries would stunt a bank’s long-term growth. It also opens the door for scrutiny of responsible finance. Public awareness of these issues is also growing, leading many consumers to make more sustainable choices.
Amid this growing pressure, most banks have made some type of commitment to net zero. However, while a bank might be reducing its own carbon footprint, the projects it finances might be more controversial.
A lot of big banks lend to fossil fuel companies and the money is often funnelled into new site development. That’s a direct conflict with the International Energy Agency’s recommendation to stop opening new oil fields in 2021 in order to hit net zero by 2050.
This begs the question of whether banks promoting themselves as a sustainable choice are guilty of greenwashing. Anti-greenwashing legislation is already in the pipeline, so it’s not only a moral question, but an operational one as well.
It’s particularly troubling for banks that operate in places where fossil fuel is still a large part of the energy mix. For example, Standard Chartered was one of the UK’s largest lenders backing coal expansion. This is in large part due to the bank’s presence in Asia, where reliance on coal is still high.
Committing to the United Nations Environment Programme Finance Initiative is one way investors can be sure banks are working to minimise this risk.
Banks will be better placed to deal with this risk with a strong net-zero policy in place, that includes a commitment to measuring and reducing scope three emissions. Part of doing that includes working with clients to cut their emissions and considering environmental risks before approving new loans.
Those that are already integrating ESG metrics into their risk analysis will be in a stronger position.
For more information about ESG investing and other ways you can do more with your money, visit the Responsible Investing section of our website.
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