What should ESG investors look for in EM banks?

2021 has been a year of tremendous acceleration in the application of ESG principles to investments across the industry. As the year comes to a close, I review our priorities for ESG in the world of EM banks and highlight the areas we’ll be looking at in 2022 and beyond.

Before explaining my conclusions, what are the key concerns of ESG investors in the EM banks space?

Governance is key, not a controversial view in global banking. A respected code of ethics is vital for the application of high standards in any bank’s daily activities and lending practices. It should also inform Board decisions and strategic choices. To the extent that ESG is involved, strict KPIs should be established and used as the basis of calculating senior executives’ variable compensation. Transparency is vital here and is aided by having a quorum of independent Board members. In addition to these internal considerations, a strong and constructive relationship with the regulator is important, particularly when it comes to managing systemic risk.

Turning to social considerations, the priorities of ESG investors in EM may differ somewhat to those of our DM colleagues. Clearly we would share their views on the importance of data security, customer privacy and labour practices. A critical concern in EM however, which is less of an issue in DM, is credit penetration and financial education. ESG investors will be highly focused on the need for poorer segments of society to gain access to finance. Education is important to help prevent the sale of unsuitable products to customers, though clearly banks themselves have responsibilities in this area too. The extent to which banks have policies that foster an increase in credit availability and financial education across society is therefore a driving concern for us when evaluating them from an ESG perspective.

Finally, when it comes to the environment, the focus must be on lending practices. It may not be fair to penalise a bank for lending to (for example) an oil company unless that exposure is egregious, because a bank that has say 20% exposure to Oil and Gas still has a much cleaner profile than any Oil and Gas company. More justified is to reward lending policies that mitigate environmental risks or encourage cleaner and more ethical activity in the company receiving the financing, whether that is reduced emissions or an increased focus on animal welfare. Along with the financial markets, bank finance is a key tool in trying to improve companies’ behaviour.

With this in mind, here are my key conclusions based on discussions with LatAm lenders this year.

Environmental

It is clear that banks are increasingly focussed on the environmental impact of their lending, which is a fairly recent development and clearly a big step in the right direction. They now all have environmental policies in place or under active development. However, the robustness of these policies differs. Major Brazilian lenders are leaders in this field, reflecting their country’s focus on the need to preserve the Amazon rainforest. They often require independent risk assessments to be undertaken and mitigation factors to be put in place before offering financing. One bank boasts an exclusion list, which is still a rarity in this area. At the other end of the spectrum are those lenders that are still working on their policies and will not have them in place until 2022. In some cases, this also reflects the looser legal framework in place and the lesser political focus afforded to environmental concerns in various countries. Politics being a key driver in this area means that there are some important areas that are scarcely addressed at all, such as animal welfare.

Disappointingly, dedicated ESG-friendly lending is still relatively small. Even for the best names, it remains well below 10% of the loan book. However, it is set to rise significantly over the coming years. This is driven not only by the widespread proliferation of new ESG-friendly credit policies but also by the sharp increase in investor demand for labelled bonds (Green, Social and Sustainable Bonds) issued by banks. We have written elsewhere about the surge in these instruments, which for banks tend to be Sustainable bonds covering both Environmental and Social projects. This will help drive further ESG-friendly lending over the coming years.

One area to watch will be the reporting standards associated both with the new lending policies and with the bond frameworks. It is currently not unusual to find banks willing and able to report the amount of environmental and/or social lending they undertake. What is harder to gauge is how this feeds into global targets, especially on climate change. Climate reporting remains quite weak and climate-related lending exclusions are almost non-existent. In EM, the former will be easier to remedy than the latter, since EMs are more reliant on (for example) fossil fuels for energy than their DM counterparts. Even COP26 sadly had to bow to this reality. But as long as climate-related reporting standards are sufficiently robust, international investors will have the tools they need to maintain pressure on banks to keep improving.

Social

As mentioned above, financial inclusion is a key focus for us in EM. Banks typically participate in government-sponsored schemes to help credit reach poorer individuals and micro companies, something that accelerated during the COVID pandemic. However, these schemes tend to be relatively small. Banks’ incentives are skewed towards financing richer people and larger companies because they are inherently less risky. It will take a combination of investor and regulatory pressure to make the banks change their behaviour, as these issues are not as high profile as the environmental ones.

The main tool used by banks and finance companies to reach the lower end of the economic pyramid is payroll lending, where loan repayments are taken out of the borrower’s salary before it is paid, limiting the credit risk to the bank. These loans are generally appropriately priced and (to varying degrees) regulated. However, they are generally only available to individuals with reliable income streams, such as pensioners and government employees. Therefore, a significant section of society is cut off from this finance, and would not be able to afford other products such as credit cards or unsecured personal loans.

The other major hole to fill on the social side is financial literacy. Although there are some programmes in place, they are not at a sufficient scale. While this gap is being addressed, which will take time, strong regulation is required to prevent exploitation which is and will continue to be a driver in our investment decisions. Regulatory competence and independence varies across the region. Banks should focus not only on making their customers aware of the risks/rewards associated with their products, but on increasing awareness of the existence of suitable products in the first place.

Finally, let’s look at digital issues. Use of digital services has expanded hugely during the pandemic (see here). In this area, things look a lot more solid. Banks generally have good systems in place to protect customers’ privacy and the security of their data. They also have controls in place to mitigate the risks of selling products online to individuals for whom they would be unsuitable. One area to watch will be the use of artificial intelligence to enhance customer relationships, as well as online marketing and the use of social media for advertising and customer monitoring.

Governance

Improvement of bank governance has been a key international policy objective since the Great Financial Crisis (GFC) of 2008. It is therefore no surprise to find that most banks have the key planks of a solid governance structure in place, including nomination and audit committees as well as a business-wide code of ethics. Given that addressing systemic risk and the weakening of the bank-sovereign nexus was another key goal of the post-GFC era, it is also not surprising to find that banks have established strong relationships with regulators. Key risks such as capitalisation and liquidity are under constant scrutiny, both from regulators and from the investor community. Transparency has also improved, especially for listed companies, though some privately owned or state-owned institutions can still be nebulous.

However, once again there are differences between banks and jurisdictions. Not everyone conforms to best practice. For instance, the number of independent directors can vary widely, from a majority of the Board in some cases to almost none in others. Many banks in EM have state ownership or state involvement or may be owned by an individual or small group of investors. Clearly, in these situations, investors will rightly question whether decisions are being made commercially. There is also a fine line between close cooperation between banks and their regulators and the relationship becoming a little too cosy.

However, it is important not to overstate this. Generally, most large listed banks have a decent governance structure in place. One area where improvement is needed is accountability for ESG goals at senior management level. Many banks do not have a Board member responsible for ESG policies, and none of them had ESG targets amongst Board KPIs. Going back to our original theme, good governance sets the tone for the whole institution. Making ESG goals a higher priority for management would set a course in that direction for the whole bank.