Integrating ESG factors into financial issuer and ABS analysis

In recent years, investors have become increasingly sensitive to the potential financial impacts of risk management failures, malpractice fines and banks’ ability to meet new regulatory standards.

These issues also present reputational risks, making the investments in bonds issued by some banks less attractive. As both lenders and issuers, banks are exposed to ESG-related risks directly and through their balance sheets. The direct risks to issuer creditworthiness are primarily governance related and, to a lesser extent, linked to customer and community relations. Looking at indirect banking risks is more complex.

To assess direct governance risks relating to banks, investors should consider organisational culture and how they might manage their balance sheet exposure to ESG risks. For example, they may consider whether the bank has a strong whistle-blower policy or risk controls. They may also consider whether it advises on aggressive tax avoidance schemes or how its financial incentives are structured. As with the defence, industrial, pharmaceutical and extractives sectors, corruption is a key indicator when assessing financial sector risk. Employee relations indicators, such as staff turnover rates, are also important to consider. Does the issuer proactively disclose these issues to investors?

To analyse indirect exposure to ESG risks, investors need to review issuer balance sheets. A telling indicator will be whether a bank proactively discloses its exposure to key ESG risks such as corruption or carbon-intensive industries like the coal sector. Another indicator could be the proportion of loans given to certain demographics that might exacerbate over-indebtedness.

“Our goal, in terms of ESG risk assessment for banks, is to understand the balance sheet ESG risk or their indirect exposure in their loan book or lending practices. The ESG research that’s out there measures the banks’ direct exposure, i.e., their resource consumption or emissions output, but not the risks investors need to know about like the bank’s exposure to climate change through its loan book and financing activities.”

Yen Wong, Colonial First State Global Asset Management

“We’re not investing in additional Tier 1 fixed income bonds at the moment in banks because we feel that the FX litigation could impact some of the returns.”

Bryn Jones, Rathbone Investment Management

Key considerations for financial sector issuers and asset-backed securities

ESG analysis for financial sector issuers should focus on governance, risk management, business culture, IT safeguards, whistleblowing provisions and compliance of individual banking units as well as the issuer as a whole.
If a bank seizes a defaulted issuers f assets, it also takes on its liabilities, which may include fines, ongoing legal costs and environmental clean-ups.
Financial sector issuers can show their commitment to managing ESGrelated risks by reporting exposure to ESG risks on their balance sheet and implementing environmental policies or proprietary ESG frameworks.

Asset-backed securities

Investors are just starting to consider how to analyse ABS from an ESG perspective. ESG analysis of ABS needs to capture risks relating to the originator of the securities, the servicer and the ‘cover pool’ of assets, respectively. Originators approach ESG analysis in the same way corporates do. Investors should also consider how ESG factors might affect the financial sustainability of ‘asset pools’ or standalone projects covering the security, such as auto loans and mortgages.

Covered bonds

Covered bonds predominantly finance residential mortgages and public sector loans. As with ABS, investors should consider ESG risks relating to the issuer and the sustainability of the assets themselves. For example, as energy prices rise and new regulations on energy efficiency are introduced, older properties are likely to become less valuable. Investors can analyse the energy efficiency of a property portfolio in relation to standards such as the UK’s Energy Performance Certificate (EPC) or the Leadership in Energy & Environmental Design (LEED) certification program in the US.