Do financials need more specialised ESG ratings & tools?

ESG factors play a crucial role in the financial industry, but whether ESG ratings effectively capture those risks is less clear.

Whether looking at who they lend to or how they operate, ESG is clearly central to banks’ risk exposure. Corporate governance – the ‘G’ in ESG – is often seen as a dominant factor for financials given the importance of risk management and accountability; if left unaddressed, governance shortfalls can result in serious ethical breaches that lead to hefty trading and reputational costs. But banks are also becoming more aware of how their balance sheets directly expose them to a wide range of environmental and social risks that can prove equally – or arguably more – costly.

All of this would suggest that ESG considerations should be a key determinant of financial institutions’ risk assessment and, much like other sectors where ESG risks are prominent, feed into the ESG ratings they secure and how the market prices that risk. One way to look at this is to probe the link between ESG ratings and asset performance, where we’ve seen a positive correlation in several sectors including food processing & automotive.

For a closer look at how ESG ratings are composed and how they’re used, click here.

ESG ratings are improving

We looked at the universe of large banks as defined by the MSCI index, composed of about 30 financial institutions with a global footprint – mostly American and European banks in near equal measure (we excluded smaller financial institutions due to data availability).

We compared these banks’ 5-year credit default swaps (CDS), effectively insurance investors purchase against a bond default, and their MSCI ESG ratings, which measures a company’s performance against a broad range of environmental, social and governance benchmarks. And we looked at whether ESG rating upgrades or downgrades affected CDS performance.

Looking at their averages over the past few years (see chart below), there has been a larger improvement in the ESG ratings for European banks, likely driven by a greater ESG regulatory push from the EU. But banks on both sides of the Atlantic have seen their ESG ratings improve.

Average ESG rating is higher and it has improved more among European than American banks (C=1; AAA=9)

Sources: MSCI and NatWest Markets

CDS spreads for the same universe (see chart below) have fluctuated significantly between 2016 and 2019. European banks have seen a steeper decrease of their CDS spreads than American ones, although current averages are almost the same – but overall, the range has declined significantly since 2016, in tandem with broadly increasing ESG ratings.

CDS spreads have declined more among European banks since 2016 (bps*)

Sources: MSCI, NatWest Markets. *bps are basis points. 1 basis point is equal to 0.01%. Higher spreads entail greater risk

Taken together, it seems there could be some link between CDS performance and ESG ratings – but it may be limited, which is not wholly unsurprising. The financial industry (like others) has increasingly prioritised ESG in recent years, reflected in a broad rise in ratings. But CDS spreads tend to be driven by more traditional financial & macro factors and industry-specific events, reflected in their relative volatility in recent years. Indeed, when looking at the static picture, it becomes much more difficult to spot any clear trend (see chart below).

AAA-rated banks generally have higher CDS spreads (bps), but they tend to marginally decrease as they move from the AA category

Source: MSCI, Bloomberg, NatWest Markets

Downgrades can hurt performance as the wider financial sector improves on sustainability

What about changes in ratings as a driver of asset performance? We have found evidence that this is the case for other sectors, so what about financials?

Since 2016, there have been 26 MSCI ESG rating upgrades (sometimes multiple upgrades for each company), skewed towards European lenders (18 out of the 26), and only 5 downgrades.

Counter-intuitively, some banks that were upgraded experienced a slightly worse performance on their CDS spreads in 2019 and 2020 compared with those that saw their rating remain constant or downgraded. However, in 2017, 2019 and 2020, banks that had their rating downgraded had larger drops in CDS spreads compared with the control group.

It’s difficult to draw industry-wide conclusions given the small number of downgrades in recent years, but this suggests ESG downgrades are more impactful when CDS spreads for the wider industry are increasing – and when ESG standards are rising across the industry.

ESG ratings: three reasons why financials stand out

That said, and given the importance of ESG factors for banks’ risk assessment, why isn’t there a better correlation between ratings & asset pricing – especially when it has been found in other industries? A few reasons come to mind:

  • ESG ratings are too discrete to capture some factors that affect banks’ profit & loss: it may seem obvious, but ESG ratings don’t capture the full spectrum of risk factors that feed into asset performance. A big trading loss may affect performance, for instance, but it may not prompt a shift in a bank’s ESG rating.
  • Aggregate ESG ratings may be too broad for financials: ESG ratings encompass a wide range of factors – from Board governance to lending practices – and may be too broad to directly affect market pricing. Some factors also have greater relevance for financials than others. Ethical breaches, for example, have much higher incidence in the financial industry, making up almost a third of the total controversies in the MSCI index (MSCI), which suggests a heightened sensitivity to corporate governance risks (versus environmental or social risks).
  • ESG factors driving bank performance may be more difficult to discern: environmental factors – the ‘E’ in ESG – have historically garnered the lion’s share of investors’ attention, but the toolkits designed to help banks quantify environmental risks (for instance, emissions from loan portfolio companies) aren’t up to scratch. Social risk factors are also starting gain more prominence as ESG investing matures. But some of the risk factors that clearly drive long-term performance – human capital development & diversity, for example – remain notoriously difficult to measure & effectively capture in ratings. Luckily, the tools & ratings investors and banks can use to understand the materiality of ESG risks are continuously evolving to better capture sector-specific nuances.

Going forward, we expect the link between ESG ratings and performance for financials to strengthen as ESG investing gathers pace, and crucially, as the tools & benchmarks available to both investors and bank treasury teams mature.

Clients who would like to discuss this topic further should get in touch of their NatWest C&I representative or contact us here.

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