Disentangling the S and the G in European banks

In their recent research, Dario and colleagues show that banks’ awareness and management of climate risk can have a positive influence on social and governance performance. They look at how the different dimensions of social and governance performance - such as human rights, workforce, and stakeholder engagement - are affected by banks' approach to climate risk.

The role of banks goes beyond simple financial intermediation. The banking system is expected to respond to broader needs in an increasingly interconnected global context, where social and governance challenges are at the forefront. Banks have a specific social function and cannot be seen in a separate context from the one in which they operate. As the various stakeholders progressively enhance their consciousness about climate-environmental and social challenges, it is arguable that the more banks have demonstrable ESG records alongside a financial return, the better their reputation is towards investors, customers, and employees, who will be more prone to invest in them and to work for them. At the same time, the regulatory context also plays a relevant role in terms of ESG pressure. For instance, the information disclosed is constantly subject to significant enhancements to improve transparency standards, according to the European Banking Authority (EBA) binding standards on Pillar 3 disclosures related to ESG risks, and within the incoming application of the Corporate Sustainability Reporting Directive (CSRD) and the European Sustainability Reporting Standards (ESRS).

In this scenario, being aware of climate change and the linked risks and opportunities could, in principle, also enhance banks’ capability to engage with stakeholders (social dialogue) and adopt sound governance practices. As the European Central Bank (ECB) expectations claim, the climate and environmental (C&E) transition poses social and governance implications. According to the concept of just transition, banks should develop a portfolio of financial services that contribute to achieving net zero in a socially inclusive manner.

Understanding the climate risk/S and G nexus

In our recent research, we show that banks’ climate risk awareness can also influence social and governance performance. Using a sample of European banks from 2013 to 2022, we highlight that this nexus is positive and significant for the social and governance pillars related to the environmental transition, such as product responsibility, community, stakeholder engagement, and management. On the other hand, climate awareness is not significantly related to human rights and workforce dimensions, suggesting that these social issues are generally not reflected in banks’ climate strategies.

Our evidence¹ enhances the understanding of how managing and disclosing climate risks and opportunities can promote social actions and governance mechanisms. Given the multi-dimensionality of ESG scores, we look in detail at heterogeneous effects across social and governance components and unveil which dimension is more affected, disentangling the sub-pillars on human rights, workforce, community, product responsibility, stakeholder engagement, equal shareholders, management scores, and using alternative measures and proxies for robustness checks.

Banks and companies generally face varying risk levels across ESG pillars, typically with higher risks concentrated in specific areas. Aggregate ratings may obscure detailed analysis of behavioral factors; disaggregated scores provide clear insights. The emerging regulatory frameworks, especially within the EU context, are becoming more targeted, focusing on specific topics while maintaining a holistic perspective (e.g., CSRD, CSDDD, TFND).

The moderating role of supervisory and risk management frameworks

Our research contributes to the growing debate on regulatory frameworks and efficient risk management practices by exploring the moderating role of risk management and supervisory mechanisms: we specifically investigate the possible role of risk culture and risk management practices in strengthening our findings. In this vein, the ECB Guide on Climate and Environmental Risks (2020) emphasizes the importance of internal control systems — i.e. risk management, audit, and compliance — for integrating climate and environmental assessment.

Interestingly, banks that are more “climate-sensitive” and embed advanced risk management methodologies (also validated by the supervisor) seem to exhibit significant attention to the interdependencies among environmental and social risks. Adopting the IRB approach for regulatory purposes demands significant technical risk knowledge and sound communications at all organizational levels. Indeed, looking at the governance dimension, advanced risk methodology validation requires banks to comply with massive requirements in terms of management policies and procedures.

The path forward

Banks and non-financial companies are progressively integrating ESG factors within their decision-making processes. In our paper, we investigate the role of climate risk and opportunity awareness in guiding European banks in enhancing their environmental, social, and governance performances, proxied by diverse ESG scores and disentangling the effects on specific sub-scores more related to social and governance dimensions of sustainable development.

Our findings underscore a sense of urgency about climate risk integration and reveal that certain social aspects are, on average, not reflected in banks’ climate awareness. This evidence may be influenced by the current regulatory frameworks that mainly focus on the path towards an environment-friendly economy (e.g., the EU Action Plan and EU Taxonomy). On the other hand, the social dimension is somewhat overlooked. Forward-looking, under forthcoming regulation initiatives, such as the Corporate Sustainability Reporting Directive (CSRD) and Corporate Sustainability Due Diligence Directive (CSDDD), companies – including banks - will be mandated to address a variety of social issues, encompassing social dialogue, human rights, community engagement. In addition, this attention to social issues and to the concept of just transition is steadily intensifying among the policymakers and academics debates.

By bridging together environmental stewardship, social conduct, and risk governance culture, banks can navigate the current turbulent context and address ambitious transition-related goals.

¹ Our observation period spans from 2013 to 2022. The data, consisting of yearly observations, are retrieved from the Thomson Reuters Refinitiv Database (now LSEG Workspace). Our final sample comprises banks headquartered in 33 countries, covering the Eurozone, the United Kingdom, the other European Economic Area, and European Free Trade Association countries and accounting for over 60% of these countries' banking system total assets

Full paper reference

Rega F., Russo S., Salerno D. “Disentangling the S and the G in the European banking industry: the role of climate risk and opportunity awareness”. Working paper (under review).

Authors

Federico Giovanni Rega

PhD Candidate at the University of Rome Tor Vergata, and Risk Manager at Cassa Depositi e Prestiti (CDP)

Simona Russo

PhD Candidate at Link Campus University

Dario Salerno

Associate Professor of Banking and Finance at the University of Naples Parthenope, and Visiting Fellow at the Centre for Business, Climate Change and Sustainability