A guest article by Credit Risk Manager at ING Germany Finn Pauckstadt: ESG risks are becoming increasingly important. But what do banks take into consideration in the lending process?
The geopolitical and macroeconomic environment remains volatile. Surveys on lending in Germany show that banks are currently still cautious about lending rather than optimistic. Factors contributing to this include not only the economic environment but also regulatory frameworks and equity requirements — and the ESG risks associated with corporate activity are playing an increasing role too. That said, ESG criteria afford banks and companies great opportunities to deepen their business relationship and set themselves apart from their competitors. Treasurers and banks should therefore address ESG risks proactively. But what's at the core of these risks?
One aspect is the impact that a company has on its socioecological environment through its business activities, that is to say the "inside-out" risk of its business model. What positive or negative effects are a company's business practices having on the climate, the environment or society? The answer to this question is hugely important for banks, as negative practices by companies also reflect on them, which has ramifications for how they are perceived by the public. If a company were then advertised with supposedly sustainable financing, the risk of attracting accusations of greenwashing would also be high.
Another aspect is that many companies are at risk of their business model transforming. Production and supply chains are under threat from changing climate and environmental factors, and not all products and services will still be relevant in the future. These physical and transition risks, as they are known, have a direct impact on a company's business model and therefore ultimately on its credit risk profile too; such risks are considered "outside-in".
Impact and transformation risks are, however, often considered separately — but only those who keep an eye on both will remain competitive in the long term. The good news is that many companies in Germany and Europe have already taken on the mantle.
Banks are facing similar challenges in that they need to assess the ESG risks of all the corporate clients in their loan book, but the requirements for this assessment are increasing. In this context, banks are currently focusing on selected issues in the lending process.
For example, banks are investigating whether companies are taking adequate measures to identify relevant sustainability risks and disclose or communicate them convincingly. They are also assessing how companies are dealing with these risks: Are they reflected in their financial and operational strategies? And can companies corroborate this approach with data and key figures?
A key aspect of the risk assessment is also whether a company can achieve its sustainability targets one time only or over multiple periods. Comparing a company with its competitors is important too, as is assessing whether there are any risks to its financial sustainability.
The quality and consistency of the information provided by companies is crucial for banks undertaking ESG risk assessments, and should be strongly aligned with the company in question's objectives. Many banks want to help their corporate clients with their transformation and are therefore looking at a long-term strategy. Companies need banks to finance this transformation. This means that transparency and open communication are key to collaboration between companies and banks when it comes to lending.
Author:
Finn Pauckstadt is a credit risk manager at ING Germany.