Despite decades of research into corporate social responsibility (CSR), the idea of CSR or Environmental, Social and Corporate Governance (ESG) has not really been strongly embraced in the realm of finance research (Zingales, 2000; Henriksson et al, 2018). This is why, in August 2019, leading US chief executives felt a need to redefine the purpose of corporations and have explicitly restated their commitment to customers, employees, suppliers and communities, which is the main objective of ESG activities. The discussions around redefining the purpose of corporations have taken a backseat as a result of the COVID-19 pandemic. However, these discussions have been reinvigorated with the launch of United Nations convened Net Zero Asset Owner Alliance in April 2021, ahead of COP26 in Glasgow, United Kingdom. This Net Zero Asset Owner Alliance also contains a Net Zero Alliance for Banks in order to address issues of climate change for the banking industry. This is particularly relevant as the issue of climate change has been termed as a real risk and a big issue for financial stability by the governor of the Bank of England, Mark Carney (Carney 2015).
Against this backdrop, a natural question arises: do banks that adopt eco-friendly policies exhibit lower risk? My co-authors and I have investigated this issue, and have found that banks that are environmentally friendly generally exhibit less tail risk. This implies that the banks that do well in terms of carbon emissions, resource reduction and environmentally friendly product innovation are perceived as less risky by investors and hence are more likely to be part of portfolio of investors and portfolio managers. We study tail risk because environmental risk is rare but is likely to have greater impact when it occurs. Tail risk is the chance of a loss due to a rare event but with huge potential impact like that of global financial crisis of 2007-08 and COVID-19 crisis. We use US (United States of America) bank data for this as US has the biggest financial industry and any problem in the US banks can be easily transmitted to the rest of the world as seen during the global financial crisis of 2007-08.
Our analysis shows that environmentally friendly banks are generally compensated in the form of lower risk. This is in line with bank regulators’ objectives as they would like to have stable banks that can ensure financial stability. This is also fortuitous for banks, as they would like their institution to be perceived as safe: this can help them raise cheaper funds. Our research provides evidence to bank regulators, bankers and investors that the risk of banks can be maintained if bank regulators encourage banks to adopt eco-friendly policies and form policies which are geared towards developing eco-friendly banks. Similarly, it helps banks to keep up with the pace and join Net Zero Alliance for Banks and align their lending and portfolio investments with net zero emissions by 2050. Finally, our research provides evidence to bankers that they can be viewed as safe banks if they adopt eco-friendly policies, and furthermore investors can reduce the risk in their portfolios if their portfolio contains eco-friendly banks.
This work was written by:
Sajid M Chaudhry
Senior Lecturer in Finance
CBP Lead Multinationals and Green Economy