- As COVID-19 continues to strain the global economy and millions of people have lost their jobs, banks have started to prepare for an increase in bad loans on their books.
- Prudent ESG lending practices, including a look at borrowers’ environmental risk management and efforts to prevent mis-selling financial products to consumers, theoretically would have resulted in better-quality loan assets.
- ESG Leaders held up better than ESG Laggards in the first half of 2020 in terms of their asset quality, while maintaining higher profitability and capitalization, which were also reflected in their credit-market performance.
Banks in most of the world’s largest economies entered the COVID-19 crisis in better shape than they did the global financial crisis (GFC).1 Yet they have generally underperformed the wider market in both equity and debt in the first six months of 2020, with performance resembling that experienced after the collapse of Lehman Brothers in 2008.2 While the financial sector prepares for a surge in nonperforming loans (NPLs), banks with stronger ESG risk management — which includes choices about whom they lend to and for what purpose — were more financially resilient, in terms of their asset quality, profitability and capitalization, in the first half of 2020.
Banks’ performance to a great extent reflects the performance of the economy around them, which contracted substantially in most countries due to the social-distancing measures imposed to fight the COVID-19 pandemic. So while the substantially higher capital and liquidity buffers they have maintained since the GFC allowed many banks to withstand the initial chaos brought about by the virus outbreak relatively unscathed, ongoing economic strain around the world will likely mean a substantial rise in NPLs — i.e., the loans where borrowers have trouble meeting their repayment schedules. That banks expect this increase is evident in dramatically increased loan-loss provisions — i.e., the amounts the banks do not expect to recover from their total outstanding loans — in the first half of 2020 across many markets (see exhibit below).3 This trend is exacerbated by the forward-looking approach to financial-asset impairments under the IFRS 9 reporting standard, which has been widely adopted since it became effective on Jan. 1, 2018.4
Year-over-Year Growth in Loan-Loss Provisions per Country (1H 2020)
Latest reported data as of Aug. 31, 2020; aggregated on country level for banks in the world’s 20 largest economies according to the World Bank’s 2019 GDP Ranking. Source: SNL, MSCI
The quality of ESG risk management may be reflected in banks’ asset quality inasmuch as it influences their decisions about whom to make loans to, for what purposes and with what conditions. This may be evident, for example, in loan-book exposure to environmentally intensive industries and decision-making processes for lending within those industries. It may also show up in retail lending practices — e.g., which client segments are targeted and what mechanisms exist to prevent mis-selling of financial products. Prudent lending policies in these areas should theoretically translate to higher-quality loan portfolios. (Robust corporate governance has also been shown to help drive better financial performance for banks.5)
To test this premise in the current environment, we looked at how the banks that entered the year as “ESG Leaders” (the top-ESG-rated banks) and “ESG Laggards” (the lowest-rated banks) held up during the initial phase of the COVID-19 pandemic.6 Because much of the virus’s impact on the global economy is yet to be seen, we focused on the forward-looking asset-quality indicators, such as additions to loan-loss reserves, in the context of their capitalization and profitability in the first half of 2020.
The ESG Leaders performed better than the Laggards on most of these indicators. Looking at nonperforming loans, ESG Leaders saw their average NPL ratio decrease slightly in 1H 2020 compared to the same period last year (flat excluding Novo Banco’s sale of its NPL portfolio in 2H 2019), while the Laggards saw it increase by 20 basis points (bps) to 3.4% of gross loans. The additions to loan-loss reserves (provisions) increased by 60 bps to 3.2% of gross loans for the Laggards in 1H 2020, while they remained flat for ESG Leaders at 2.2% (30-bp increase to 2.5% of gross loans excluding Novo Banco).
Asset Quality, Profitability and Capitalization Development over Last Five Years
Data as of Aug. 31, 2020; the full dataset consists of 560 companies (51 ESG Leaders; 76 ESG Laggards) in the GICS banks industry with available MSCI ESG Rating as of Dec. 31, 2019. *NPLs and loan-loss reserves represented in % of gross loans. **CET1 ratio as common equity Tier 1 capital relative to risk-weighted assets. Source: SNL, MSCI
Lower asset quality is not necessarily a problem, provided it is adequately offset by higher margins and sufficient capital buffers to deal with unexpected losses. However, credit costs also skyrocketed relative to income, bringing down the return on equity for both ESG Leaders and Laggards. As the struggling economy and ultralow interest rates globally put a strain on banks’ top-line income, those with worsening asset quality may be in a weaker position to offset the losses with higher margins in the near term. ESG Leaders were also better capitalized than the Laggards, which typically has provided more flexibility to deal with additional increases in credit losses.
We believe these factors may have also contributed to ESG Leaders’ showing better resilience during the market sell-off in March 2020.
Option-Adjusted Spreads (in bps) for ESG Leaders and Laggards During 1H 2020
MSCI’s calculation is based on the (unweighted) performance of Bloomberg Barclays Global Aggregate Index constituents in the GICS banks industry with available MSCI ESG Ratings between Jan. 1, 2020, and June 30, 2020. Option-adjusted spread is a common measurement of how much fixed-income issuers must pay investors to compensate for risk; specifically, it is the spread between a bond’s yield and the risk-free rate of return, adjusted to reflect embedded options, such as the issuer’s right to call in the bond.
1“The EU Banking Sector: First Insights into the COVID-19 Impacts.” European Banking Authority, May 3, 2020. “Financial System Report” Bank of Japan, April 8, 2020.
2Aldasoro, I., Fender, I., Hardy, B., and Tarashev, N. “Effects of Covid-19 on the banking sector: the market's assessment.” Bank for International Settlements, May 7, 2020.
3U.S. bank loan-loss reserves have risen by USD 110 billion since the crisis began, the highest level since 2012. See: Armstrong, R. “Upbeat bond market at odds with banks over scale of Covid risks.” Financial Times, Sept. 29, 2020.
4“IFRS 9 Financial Instruments.” IFRS Foundation.
5Lee, L.-E., Giese, G., and Nagy, Z. “Is ESG All About the ‘G’? That Depends on Your Time Horizon.” MSCI Blog, June 15, 2020. “ESG and the credit quality of the world’s largest banks.” MSCI ESG Research, March 10, 2020. (Available on ESG Manager)
6The full dataset consists of 560 companies (including 51 ESG Leaders and 76 ESG Laggards) in the Global Industry Classification Standard’s (GICS®) bank industry with available MSCI ESG Ratings as of Dec. 31, 2019. ESG Leaders = AAA, AA; ESG Laggards = B, CCC. GICS is the global industry classification standard jointly developed by MSCI and Standard & Poor’s.
Banking on ESG: Examining the financial relevance of ESG to banks