Volume 15 (2022)

Each volume of Journal of Risk Management in Financial Institutions consists of four 100-page issues, published both in print and online.

The papers and case studies confirmed for Volume 15 are listed below:

Volume 15 Number 4

Editorial: A cooperative equilibrium
Julie Kerry, Publisher
Practice papers
From modelling to forecasting bank profitability: Evidence from euro area banks
Marco Belloni, Risk Officer, Swiss Re, Mariusz Jarmuzek, International Monetary Fund and Dionysios Mylonas, European Central Bank

Building on the established bank profitability literature, this paper develops models encompassing macroeconomic and banking variables and assesses their forecasting performance. Understanding factors underpinning bank profitability is important for the design and implementation of stress tests, which have become one of the integral elements of bank risk management frameworks and capital planning. Results from the data for euro area banks suggest that particular attention may need to be paid to quantifying and managing interest rate risk. In addition, with the identified relevance of capital position and credit risk, additional efforts may be needed to monitor the ensuing risks. Results also suggest that models relying solely on macroeconomic variables do not perform significantly worse in terms of forecasting accuracy compared to richer specifications and can beat the autoregressive models over the medium term. Bearing in mind the costs associated with development, validation, and maintenance of more complex models underpinned by richer specifications, the results point to the potential use of presented or similar models by regulators, supervisors, and banks in their respective roles in the context of supervisory review and evaluation processes.
Keywords: bank profitability modelling; panel data analysis; forecasting; stress testing; bank regulation and supervision
CRR III implementation: Impact on capital requirements, performance and business models of European banks
Martin Neisen, Partner, PricewaterhouseCoopers and Hermann Schulte-Mattler, Professor, Dortmund University of Applied Sciences and Arts

The European Banking Package II finalises the implementation of the final Basel III standards, which the industry refers to as ‘Basel IV’. It entails many changes to the methods used to determine capital requirements and represents a significant challenge for the European banking sector. Based on the Capital Requirements Regulation (CRR) III draft, this paper provides an overview of the main implementation issues in the European Union, discusses the potential impact on banks' capital requirements and makes policy recommendations. This paper uses primary sources such as the Basel Committee on Banking Supervision, the European Banking Authority and the European Commission. Secondary sources, academic articles or analyses from various stakeholders are also included in the analysis. This paper also provides an analysis of the impact of the new prudential regulations on banks based on 30 detailed Basel IV impact studies conducted over the past two years in consulting projects with banks from almost all EU countries. The impact analysis covers a wide range of different business models, bank sizes and countries. We believe the anonymised data we use is far more representative of the EU banking system and other jurisdictions than the impact studies performed by the European Commission or the BCBS. The new CRR III regulations will pose strategic, operational and regulatory challenges for the banks concerned. The paper concludes that the European implementation of the reforms will not burden a specific group of banks, but banks with different business models and of different size will be impacted differently but still significantly. This makes Basel IV and CRR III unique compared to previous reforms of the Basel framework. The EU Commission's goal of proportionality of regulations will not provide much relief in this regard. The paper provides an up-to-date and comprehensive overview of the planned changes in CRR III, ie in capital adequacy requirements. It analyses the implementation of the standards and compares them with the Basel IV requirements. Recommendations for supervisors, risk management practitioners and other interested parties conclude the paper.
Keywords: Basel III finalisation; Basel IV; credit risk standardised approach (SA-CR); internal ratings-based approach (IRBA); operational risk
Bounded rationality in bank credit decisions for SME lending: Evidence from bankers in Malaysia
Nigel Kollin-Ondolos, MSc Student, Faculty of Business and Management, Universiti Teknologi MARA, et al.

A behavioural finance perspective offers possible ways for bankers to enhance small and medium-sized enterprises’ (SMEs) access to financing and the quality of a bank's credit portfolio but is neglected in the present bank policy and practice. This paper studies the fundamental and behavioural factors that determine credit decisions for SMEs by bank officers in Malaysia using the theoretical lenses of bounded rationality. In finding ways to reduce behavioural biases, the effect of the human capital factor on credit decisions is examined. The data for the study were obtained from 161 bank credit officers in development financial institutions and commercial banks by using stratified random sampling that sufficiently represents the local banks' population in Malaysia. Hierarchical multiple regressions were used to examine the relationship between the fundamental factors, behavioural factors and human capital factors on bank officers' credit decisions on lending to SMEs. In the assessment of the fundamental factors, regression results showed that character and condition have a positive relationship with the credit decision making. In the behavioural factors assessment, intuition, optimism and overconfidence are influential in behavioural credit decision making, while the interaction analysis shows that credit experience and emotional intelligence can reduce the influence of behavioural factors on bank officer credit decisions for lending to SMEs. Generally, the findings of this study confirm the theoretical framework of the bounded rational credit decision and would be valuable in enhancing the theory, practice and policy regarding lending to SMEs, particularly in minimising behavioural biases in lending decision making. This research offers bounded rational perspectives on bank credit officers' decisions. The research framework revealed that bank credit officers are influenced by both rational (fundamental factors) and irrational (behavioural factors) in their credit assessment and decision-making process. Presumably, the influence of behavioural biases could have negative effects on SME financing access and credit portfolio quality. In addition, the framework provides insights into ways to reduce behavioural biases to improve rationality in credit decision making and credit portfolio quality.
Keywords: behavioural finance; bounded rational; business banking; credit analysis; SMEs' finance
Nexus between liquidity risk and credit risk: Evidence from the South Asian region
Ajab Khan, Faculty of Business, Law and Digital Technologies, Southampton Solent University and Mustafa K. Yilmaz, Professor, School of Business, Ibn Haldun University

This study investigates the reciprocal relationship between liquidity risk and credit risk and their individual and joint impact on the stability of commercial banks in the South Asian countries, ie Pakistan, Bangladesh and India, from 2004 to 2016. The results reveal that liquidity risk and credit risk have a significantly positive reciprocal and economically meaningful relationship. Each risk type individually and jointly negatively affects banking stability. This impact has been more observable during the global financial crisis. The findings provide valuable insights for bank managers and regulatory authorities. Banks should be more concerned about mitigating their liquidity and credit risks by managing more qualified loan portfolios and investing in less risky liquid assets.
Keywords: banking stability; credit risk; liquidity risk; South Asia region
Analysing climate risk in the banking sector: To what extent should the onus be on banks to fund the ‘green deal’ while focusing on their own climate change and ESG risk profile?
Richard Bennett, CEO, Razor Risk

Planet Earth's temperature has risen by about 1.1 degrees Celsius on average since the 1880s, confirmed by satellite measurements and by the analysis of hundreds of thousands of independent weather station observations from across the globe. This rate of warming is in an order of magnitude faster than any found in the past 65 million years of paleoclimate records — the rapid decline in the planet's surface ice cover provides further evidence of this. The banking industry is the custodian of global finance. It therefore has a central role to play in mitigating against this trend. After all, these are the institutions that occupy a key position as important catalysts in reorienting financial flows towards sustainable activities, supporting industries and governments in meeting climate risk and their environmental, social and governance (ESG) targets. However, should the onus be on the banking sector to drive this agenda? Yes, it has an important role to play, but should it be writing the overall global narrative? We will look at what banks are doing now to measure, and act upon, their own climate risk and ESG profile, and look at how much we should expect them to fund the overall ‘green deal’ or ‘clean’ strategy throughout 2022 and beyond. However, let us not forget, the banking sector has been focussing on money rather than ESG matters for centuries. For those new to the subject, we will also use this paper to provide some step-by-step advice and suggestions for what banks should be doing now to prepare for ESG issues. The paper opens with the theory, then moves into the practical, with a series of first-hand case studies. These cover the measures that Razor Risk's banking clients have been introducing to mitigate against climate risk, providing a critical reference point for the sector as a whole.
Keywords: ESG; risk management; climate risk; credit risk; liquidity risk; operational risk; regulatory risk
Oversight and risk management of payments schemes
Piet M. Mallekoote, Independent Adviser and Supervisor and Suren K. Balraadjsing, Scheme Auditor, Currence

Retail payments have become a strategic item on the agenda of the boardrooms of banks and fintechs. Innovation and competition in methods of payment have increased significantly over the past decade, resulting in more choice and better customer experiences for consumers. The downside of this positive development is that the risks in payments have increased. This paper analyses these developments and shows why and how the oversight of central banks has spread to retail payments. It also discusses how owners of payment schemes can respond to this by setting up an adequate risk management system that monitors the main risk areas, but also takes into account changes and innovations in the payment landscape due to technology and legislation.
Keywords: scheme management; risk management; oversight of payment schemes; operational risks; cyber risks; third-party service providers; payment chains
Cybersecurity skills of company directors — ASX 100
Nigel Phair, Director (Enterprise) and Hooman Alavizadeh, UNSW Institute for Cybersecurity, UNSW Institute for Cybersecurity, University of New South Wales

Cyberattacks on companies cause huge financial loss all over the world due to lack of cyber risk awareness of companies. Understanding cybersecurity risk is crucial for company directors. In this paper, we analyse the cybersecurity skills of the directors listed on the top 100 Australian Securities Exchange (ASX 100) ranked by market capitalisation. By analysing the background and skills set of the non-executive board members of ASX 100 companies, we were able to observe that only 1.8 per cent of non-executive directors have cybersecurity knowledge and background. Interestingly, a majority of directors (around 78 per cent) have knowledge in neither technology nor cybersecurity realms. Moreover, only 7 per cent of ASX 100 companies have at least one director with cyber and technology knowledge and background.
Keywords: cyber; cyber security; cyber skills; company directors; ASX 100

Volume 15 Number 3

Editorial The inflation narrative
Tom Grondin, Chairman of the Board, Transamerica Life Bermuda
Practice papers
A strategy road map for small and medium-sized banks from a Canadian perspective: Transformation from start-up to mid-size and beyond
Bogie Ozdemir, RiskVision

One item on the regulatory agenda is the need to increase competition in the financial system. Financial technology is replacing bricks-and-mortar distribution channels, reducing the need for economies of scale that has been a barrier to entry and growth. Financial services are being unbundled and the large banks, being financial conglomerates, face losing their grip on the market, as space is opened up for the lower-cost specialised providers of financial services that offer superior customer service. This is an opportunity not only for neobanks but also for smaller traditional banks that can update their skills and adapt. In Canada, small and medium-size traditional banks are trying to seize the opportunity. They continue to deploy a lending-based business model while taking advantage of FinTech for operational efficiency and digital distribution channels. They are also working towards AIRB licences in order to become capital efficient and increase their addressable market. Nevertheless, they face formidable challenges including their intolerance to loss, more expensive funding, more expensive and higher capital requirements, and the big banks’ market power. This paper discusses the risk strategies these banks can employ in their journey from start-ups to mid-sized and beyond. We provide numerical examples using the ROE framework.
Keywords: FinTechs, start-ups, strategic risk, strategic positioning risks, strategic execution risks, strategic governance risks
Systemic risk analysis and SIFI detection: Mechanisms and measurement
Luca Riccetti, Associate Professor of Economics, University of Macerata

This paper introduces the relevance of systemic risk measurement in the financial system, and the related issue of identifying systemically important financial institutions (SIFIs), in an evolving regulatory framework. It goes on to perform a detailed review of systemic risk mechanisms (both in the short and medium run), highlighting the interaction between solvency and liquidity problems. The paper also discusses how systemic risk should be measured. Finally, the paper puts forward some high-level suggestions on the use of multi-layer network simulation to measure systemic risk.
Keywords: financial systemic risk; systemically important financial institutions (SIFIs); liquidity risk; solvency risk; multi-layer network simulation
The generation of synthetic data for risk modelling
James Hurst, Vice President and Head of Enterprise Risk Management, Kirill Mayorov, Vice President and Head of Model Development and Joseph Francois Tagne Tatsinkou, Senior Model Development Manager, Equitable Bank

Both recent advances in technology and changes in regulatory requirements have led to the increased popularity of advanced analytical techniques in risk management. These techniques are data intensive and therefore require a minimum amount of historical data. Financial institutions often have limited historical data available, due to the cost or to incomplete data collection in the past. This paper proposes an approach for generating synthetic data that allows risk parameters, such as probabilities of default (PDs), to be quantified when data are limited. The approach consists of imputing synthetic model drivers within an existing data framework by leveraging partial historic data and/or information derived from expert opinions or external sources. Synthetic proxies are produced for drivers with no data, limited data or data of poor quality. The synthetic drivers are generated consistently to adhere to existing or expert-driven correlations among all variables. In a logistic regression setup, the authors illustrate the approach using stylised data from real estate transactions and show how model performance metrics of PD estimates can be improved. The authors conclude that a financial institution with limited or no historic data on important model drivers can use expert views or publicly available data to improve estimates of risk parameters.
Keywords: risk quantification; risk management; probability of default; simulation; synthetic data; logistic regression
Best practices in combating fraud in financial institutions
John Mahony, Head of Compliance and MLRO, Atrato Group

This paper intends to provide the reader with practical steps to take when establishing a framework for combating fraud.
Keywords: best practice; internal fraud risk; corruption risk; combating fraud
Climate change risk: Demands and expectations imposed on banks
Udo Milkau, Digital Counsellor

For several years, there has been discussion about whether climate change risk is a fundamentally new type of risk or can be subsumed under market, credit, operational and systemic risk in the financial industry. The European Central Bank’s current ‘climate risk stress test’ is a milestone marking a shift in that discussion, from a normative one to a perspective on actual exposures and quantitative data. This shift is linked with regulatory guidelines about how climate change risk should be integrated into banks’ risk frameworks, but also comes with some expectations for banks to actively steer funding to the green transformation. We now understand climate change better than ever and are able to estimate the physical damages it will cause (ie the estimated probability distribution of damages from additional ‘extreme events’). This can be mapped to credit exposures by region (eg river valleys) and by industry segment (eg agriculture) as elaborated in the ‘climate risk stress test’. This paper provides a first step for extending the approach from actual exposures to expected losses by comparing the effects of ‘normal’ weather events with the additional climate-change-related events. However, sophisticated models are required to separate the climate-change-related excess of rare but severe events from extreme weather events that are not related to climate change. In contrast to the earlier static concept of ‘stranded assets’, a ‘transition risk’ would be the result of ‘disorderly’ pathways to a low carbon economy rather than a transparent and consistent road map. A sudden and abrupt increase in the price of carbon (or of greenhouse gas emissions in general) would travel along a transmission chain in the economy, eventually affecting banks’ credit and market risk exposure. Determining the effect of such a step function on an estimated loss distribution is methodologically challenging, especially because there are limited data on historical events. The actual transmission will be even more complicated as political decisions interact with social acceptance and there is a (new) risk of the lack of societal consensus. This paper discusses this challenge, using a schematic model of the political decision on and societal reaction to carbon prices and the consequences for carbon-intensive industry sectors and consumers and citizens. Finally, regulators have expectations of how banks should contribute to a ‘green deal’ and bridge the gap between political commitments and economic measures. This task for the financial services industry — ‘steering credit’ — turns out to be a new source of risk for the societal ‘licence to operate’, into which more insight is required. This paper disentangles the various elements as a step towards a better understanding of the challenges that climate-change related risk poses to banks.
Keywords: Climate change risk; extreme weather/climate events; transition pathways; societal consensus; duty of care; licence to operate
Book review
Where Next for Operational Risk? A Guide for Risk Managers and Accountants
Dr Tom Butler, University College Cork

Volume 15 Number 2

Editorial
Klaus Böcker, Senior Manager, PricewaterhouseCoopers and Editorial Board Member, Journal of Risk Management in Financial Institutions
Practice papers
The strategic risks facing start-ups in the financial sector
Patrick McConnell, Consultant

The majority of start-ups fail. But some succeed, and a very small number succeed spectacularly. And it is the stories of the sometimes vast wealth unlocked by the rare successes that drive entrepreneurs, with stars in their eyes, to embark on a start-up venture. Even though the odds are stacked against them, people still invest their time, effort and wealth pursuing their dreams. Start-ups are risky — very risky — and thus any efforts to reduce the enormous risks facing start-up founders must increase the odds of ultimate success. Risk management, therefore, should be a key focus for entrepreneurs and their investors. One of the many types of risk facing every firm is ‘strategic risk’, although for established companies this overarching risk is somewhat mitigated by their deep knowledge of the industries in which they operate and not least by their ready access to capital to grow their business (provided of course that the firm is not already in trouble). There are very many definitions of ‘strategy’ in business, but one, from the guru of competitive strategy, Michael Porter, is simple and clear: ‘[a strategy is] a broad formula for how a business is going to compete, what its goals should be and what policies will be needed to carry out those goals.’ So, if the founders of any company do not know how and with whom the firm is going to compete, what the goals/objectives should be, and how founders plan to achieve those goals, then their venture is unlikely to succeed. This paper identifies some of these critical ‘strategic risks’ by first identifying what is ‘strategy’ and why it is important, especially for start-ups. Then, using common strategy models, key risks for any company and some of the key strategic risks facing start-ups in finance are described. In particular, one extremely important aspect of strategic risk, that of strategic positioning risk, is covered in detail. There is no ‘magic bullet’ to eradicate risks, especially strategic risks, but to illustrate how strategic risks may, to a degree, be mitigated, the paper references three case studies of start-ups in the financial sector: one that has succeeded (to date), one that has failed and one somewhere in the middle. In these cases, the paper does not claim that success or failure is a result of formalised risk management processes, more that key decisions taken along the way addressed some critical strategic risks. The purpose of this paper is not to frighten entrepreneurs with the enormous task confronting them, but to provide a rough map of some terrain to avoid along their journey. There will be many potential pitfalls for every start-up — it makes sense to try to avoid some of the more obvious.
Keywords: FinTechs, start-ups, strategic risk, strategic positioning risks, strategic execution risks, strategic governance risks
Satisfying exclusions in portfolio construction: The ESG case
Amel Bentata, Senior Quantitative Analyst and Laurent Nguyen, Team Leader, Pictet Asset Management SA

In this paper, we show that quantitative portfolio construction techniques can deal with ‘reasonable’ constraints and deliver most of the expected (ie before constraints) value-added. To do so, we use the case of a hypothetical environmental, social and corporate governance (ESG) investor who chooses to not invest in companies typically excluded for ESG reasons (eg weapons manufacturing, nuclear energy generation, tobacco or high carbon intensity) back in the late 1980s. While satisfying ESG objectives, we capture the market’s exposure using several portfolio constructions such as pro-rata cap-weighting and minimum tracking. We also capture other ‘styles’ that could mimic exposures some asset owners want to be exposed to, such as value or momentum. Our results are helpful to deliver an appropriate, risk-controlled investment experience to asset owners who must integrate externally defined constraints in their long-only equity investments.
Keywords: ESG, constraints, optimisation, Markowitz, equities
Outsourcing insurance in the time of COVID-19: The cyber risk dilemma
Hala Naseeb, Insurance Practitioner, Bahrain Institute of Banking and Finance and Abdelmoneim Metwally, Assistant Professor, Assiut University

With the shift towards teleworking/working from home in recent years and accelerated by the COVID-19 pandemic, insurers are finding themselves relying on outsourcing as a way to cope with changes in business models and requirements. This has augmented the risk of cyberattacks and is ultimately considered a high risk for insurers of any size, not only because it subjects insurers to litigation concerning data breaches, but also because of the harm to the insurer’s reputation when an attack happens, which is further magnified by resultant loss of system use. Clients already have the perception that insurers are too invasive when it comes to personal data (especially in the medical and life insurance fields), so they are blamed for not handling cyber risk meticulously regardless of whether it is the outsourcing provider’s fault. Risk managers in insurance companies need to apply enterprise risk management (ERM) principles and identify cyber risks across the entire process to manage these risks. The paper proposes some potential policy solutions that would help insurers mitigate outsourcing cyber risks. Further research is required in this field, specifically into what strategies insurers are implementing to deal with the risks posed by the outsourcing provider’s cyber risk and which of those strategies have fared better than others thus far.
Keywords: cyber risk, telework, COVID-19, insurance, outsourcing, technology
Banks’ concurrent risks during the COVID-19 pandemic: A road map for risk officers and risk management
Ahmed A. Diab, Assistant Professor, Prince Sultan University, Abdelmoneim Metwally, Assistant Professor, Assiut University, Abdulkarim M. AlZakari, Chief Risk Officer, Khaleeji Commercial Bank and Aisha Fazal, Senior Lecturer, British University of Bahrain

In the banking literature, the global financial crisis of 2008/09 is cited as one of the key challenges that faced the modern risk management profession. When we look at the current situation of the COVID-19 pandemic, however, we realise that banks worldwide are facing more concurrent risks that need interventions. This paper analyses the impact of the COVID-19 pandemic on the banking sector worldwide, focusing on emerging markets such as Bahrain. In doing so, a road map for banks’ risk managers is proposed. In particular, we present specific recommendations for local and central banks to manage the emerging risks following the pandemic, including operational resilience and increased financial, market and credit risks. Further, we provide some insights and recommendations for the Bahraini banking sector, as an example of an emerging financial market.
Keywords: risk management, banks, COVID-19, financial risks, operational resilience
Research papers
Impact of COVID-19 on commercial banking risk management practice: Survey evidence recommendations for practitioners
Jamal M. Shamieh, Assistant Professor, American University of Madaba

This study aims to discuss the impact of COVID-19 on commercial banking risk management practice. The study used a qualitative study design based on three different approaches: use of primary sources such as journal articles, focus groups and observations on digital trends. The impact of COVID-19 on risk management in commercial banks manifested in many areas such as deteriorating credit quality, increased cash outflows and reliance on digital systems. This study offers practical solutions for mitigating risk in various areas for the banking industry through survey evidence recommendations for practitioners. Although other studies identify the major risks, this study focuses on how to deal with each of these risks.
Keywords: COVID-19, stress event, risk management, commercial banking, qualitative design, focus group
Managing the COVID-19 pandemic: Preliminary evidence from global banks
Paolo Agnese, Associate Professor, Faculty of Economics, International Telematic University UNINETTUNO, Paolo Capuano, Contract Professor, LUISS University of Rome and Alberto Romolini, Associate Professor, International Telematic University UNINETTUNO

The COVID-19 pandemic represents the most complex test for financial institutions since the global crisis of 2007. During this period, the boards of financial institutions, especially banks, had to make strategic decisions quickly, to address the effects of this crisis efficiently and effectively. Boards had to make the right decisions to withstand the shocks caused by the pandemic. The role of the board (or supervisory board) in managing banks has been under scrutiny by academic researchers and professionals during the current pandemic crisis. Since the outbreak of COVID-19, boards have faced many tough decisions. Boards promptly facilitated the introduction of a number of COVID-19 response policies, including the establishment of specific teams to prevent and control the effects of the pandemic, to support the community, and to the protect and support employees and clients. The objective of this paper is to understand the role of boards of global banks during the COVID-19 pandemic, in particular to determine which were the most effective policy decisions and to outline the related underlying trends. The results of this research may allow the identification of best practices for the management of financial institutions,and provide a useful reflection for the various stakeholders, including regulatory and supervisory authorities.
Keywords: global systemically important banks (G-SIBs), board of directors, corporate governance, COVID-19 pandemic
Building bridges: From the probability of a country crisis to a country risk assessment
Alexandre H.O. Siqueira, Senior Credit Risk Analyst, BNDES

Country risk is often misconceived, leading to misunderstanding and, consequently, misapplication. This paper aims to provide an alternative way to assess country risk, based on quantitative tools where the link between country crises, firms’ characteristics and country risk ratings are presented. This paper reviews the literature on country risk concepts and develops a theory for the impact of country risk on the real economy, in particular how the outcome, provoked by a country crisis, effects firms’ assets. A statistical model based on the probability of a crisis adjusted to firm idiosyncratic exposure to country risk is built with respect to the type of exposed asset. The proposed assumptions that country risk alone does not exist, and that country risk must be combined with the primary source of risk to be measured, are rooted in natural science concepts about vulnerability and hazard and are the essence of this paper. The model is forward looking based on the probabilities of the occurrence of countries’ crises, providing an economic foundation for the additional cost of capital that country risk represents. This methodology could provide additional help to investors and banks.
Keywords: Country risk, country crises, sovereign risk, country risk ratings

Volume 15 Number 1

Special Issue: Advances in ESG: Integration, risk management and thematic investing

Guest Editors: Dr. Luis Seco, CEO, Sigma Analysis & Management, Professor of Mathematical Finance, University of Toronto and Alik Sokolov, CEO, SR.ai, PhD Candidate, Mathematical Finance, University of Toronto

Editorial
Dr. Luis Seco, CEO, Sigma Analysis & Management, Professor of Mathematical Finance, University of Toronto and Alik Sokolov, CEO, SR.ai, PhD Candidate, Mathematical Finance, University of Toronto
Opinion piece
Is ESG investing contributing to transitioning to a sustainable economy or to the greatest misallocations of capital and a missed opportunity?
Dr Madelyn Antoncic, Member of the Board of Directors ACWA POWER, Saudi Arabia; S&P Global Ratings & FinTech Acquisition Corp VI, USA

Environmental, Social and Governance (ESG) investing has become a focus not only of the asset management industry but also among policy makers as a way to mobilise capital for sustainable economic development. While this could be the mechanism through which capital is allocated to companies and technology of the future to help transition to a net-zero sustainable economy and to deliver on the UN SDGs, all of the ‘noise’ around ESG reporting coupled with the ESG ‘investing frenzy’ may more likely end up being the greatest misallocation of capital and a missed opportunity. Asset owners’ strong interest in investing in ‘green’ assets to transition to a net-zero sustainable economy has led to a growing trend of asset managers labelling and rebranding mutual funds and ETFs as ESG and even mainstream funds are advertising employing ‘ESG integration’. At the same time, significant ‘greenwashing’ exits at the company reporting level due to the lack of agreed standards. Moreover, poor correlations across ESG score providers for a given company as well as intentional built-in biases introduced into the scoring and the total lack of any analysis taking into account ecological ceilings, sustainability thresholds and outer boundary limits of natural resources, will all likely lead to material capital allocation distortions. ‘Greenwashing’ at both the asset manager and the corporate level and the resultant misallocation of capital is likely setting the stage for potential risks including significant macroeconomic and geopolitical risks, as well as risks to the financial markets and financial institutions.
Keywords: ESG, transition to a net-zero sustainable economy, Paris Agreement, UN SDGs, European Green Deal, climate risk
Practice papers
How can climate risk stress testing be implemented?
Greg Hopper, Managing Director, Goldman Sachs

This paper is a practical introduction to the nascent methodology of climate risk stress testing. After giving a general overview of the physical climate models that underlie climate risk projections, it discusses how a financial institution can leverage open-source physical risk data and climate models employed by the scientific and policy communities to perform both physical and transition risk stress tests. The paper develops two examples of physical risk stress testing: 1) a stress test of the effect of temperature increases on labour productivity; and 2) a stress test of the physical damage of hurricanes. The paper goes on to explain what transition risk is and then explores how models already in use by the climate policy community can serve as a foundation for transition risk stress testing.
Keywords: Stress testing, climate risk management, physical risk, transition risk, climate scenarios, climate models
Quantifying climate risk uncertainty in competitive business environments
Jorge R. Sobehart, Managing Director and Head of Credit and Obligor Risk Analytics, Citi

As the impact of climate change and CO2 emissions gain more visibility globally, there is increased interest in understanding how the industry landscape will be reshaped in response to the changing physical, economic and political environment. This paper introduces an approach for quantifying the risks associated with the release and adoption of competitive products and services for the long-term uncertainty generated by climate risk scenarios. Our approach can be used for assessing the risks of business strategies whose revenues are used for the repayment of obligations in industries affected by climate risk or CO2 emission costs, and for estimating the probability of default on those obligations under different scenarios. Our approach can also help gain insight into the uncertainty of different net-zero emission strategies and into the uncertainty of outcomes due to nonlinearities, synergies and model misspecification.
Keywords: Climate risk, transition risk, competitive environments, earnings uncertainty, credit risk, disruptive technologies
Managing climate change risks: The role of governance and scenario analysis
Laurent Clerc, Director for Research and Risk Analysis, Autorité de Contrôle Prudentiel et de Résolution

Climate-change and environmental risks, as illustrated by extreme weather events and biodiversity losses, pose a fundamental threat to humanity. Calls for action have intensified and pressures on the financial sector have significantly increased. As a result, environmental, social and governance (ESG) disclosures and risk assessment have improved. In this context, this paper highlights the crucial role of governance and scenario analysis in enhancing the effectiveness of climate-change and environmental risk management. Concrete examples are given, drawing on some results of the unprecedented ACPR pilot climate exercise, to illustrate the importance of scenario analysis.
Keywords: ESG, climate change, risk management, governance, stress testing, scenario analysis
How to improve the ESG profile of portfolios while keeping a similar risk-adjusted return
Antoine Kopp, Dominic Barber, Rémy Cottet and Gabriele Susinno, Pictet Asset Management

This paper identifies the potential to improve ESG credentials of a given reference portfolio whilst broadly maintaining risk-adjusted return characteristics, hence anchoring the portfolio to a better ESG profile. ‘Improving’ in this case means allocating a higher weight to better ESG stocks according to the variables employed. Using different MSCI benchmarks as reference portfolios, the research shines light on interesting subsector dynamics in the ESG-tilting process. Namely, Banks and Pharmaceuticals are replaced by Insurers and Real Estate Investment Trusts, in addition to Healthcare providers. The paper provides significant findings for investment managers in the context of ever-increasing pressure to ‘do good whilst doing well’. The opinions expressed in this paper are solely those of the authors.
Keywords: ESG, portfolio construction, risk-adjusted return, sustainable investing, socially responsible investing, convex optimisation
ESG rating as input for a sustainability capital buffer
Martin Neisen, Partner, Benjamin Bruhn, Manager and Dieter Lienland, Director, PricewaterhouseCoopers

In this paper, we give a state of the art overview of what ESG ratings are, which different types of these ratings can be distinguished and how they could be used in banking regulation to adjust banks’ capital requirements with the goal to promote green finance and reduce climate-related risks within the investments of banks. Based on experience collected with other supporting factors within banking regulation, like the SME supporting factor, we show how a Green Supporting Factor or a Brown Penalty Factor could be implemented to promote green finance or punish brown finance, respectively, and include climate risk into Pillar I capital requirements. We also discuss an approach combining these two binary factors and conclude with a proposition to use ESG ratings to derive capital requirements add-ons. After all, ESG ratings take a broader perspective on sustainability and provide a more granular scale ranging from sustainable to non-sustainable rating classes. This approach ensures that green finance investments can be promoted via adjustments of capital requirements without a significant decrease of the total capital in the banking sector and, therefore, without the reduction of the stability of the financial market.
Keywords: Basel IV, ESG ratings, green supporting factor, capital buffer, SREP, sustainability buffer
Climate change risk: The next frontier in banking risk management
Hanna Sarraf, Group Chief Risk Officer, Bankmed Group

Extreme weather events are becoming more frequent, more intense and, to a certain extent, more predictable, according to global climate research. Over time, the effects of climate change could alter dramatically the environment upon which communities, societies and economic activity depend. Meanwhile, a correlating impact on firms, sectors and geographies could render traditional business models ineffective or obsolete. Rapid developments in environmental, social and governance (ESG) initiatives, and rising stakeholder demand for improved sustainability performance, will require banks to take a more integrated and strategic approach to climate risk management. This paper explores the practicalities of integrating climate-related risks into existing risk management frameworks, strategies and processes. It examines the key components and attributes of an effective climate-risk framework. And it elaborates on some of the unique characteristics and business model adaptations that are needed to incorporate climate-change considerations into decision-making processes, including capital allocation, loan approval, portfolio monitoring and reporting. In this way, business models can become more economically efficient and strategically resilient to climate risk and equipped to deliver long-term sustainability and value creation.
Keywords: ESG, climate change, environmental risk, climate risk management, banking business model sustainability, strategic resilience
Winning a seat at the ESG table
Jonny Frank, Partner, Jim Barolak, Partner and Germari Pieterse, Managing Director, StoneTurn

Financial Institutions (FIs) struggle to identify, assess and develop appropriate responses that proactively address potential events for more traditional known risks let alone new, emerging and imprecise risks in the often difficult-to-quantify Environmental, Social & Governance (ESG) space. ESG-related risks present even greater challenges to established risk management frameworks such as COSO because ESG risks are generally not well known to the business and include ‘black swans’ or other unforeseen events that can challenge the entities’ short-term or long-term performance or even survival; tend to be longer term in nature than the timeline with which strategy is set or risks have been considered historically; and beyond the scope of any one entity. The good news is that FIs’ existing — and often highly sophisticated risk, compliance and legal functions (Risk Team) — are well equipped to integrate and mitigate these significant ESG-related risks into the FI’s risk management framework. The authors, drawing upon first-hand experience as government-appointed monitors for large, global financial institutions, provide a practical roadmap for defining and mapping ESG-related risks. They also explain why Chief Risk Officers, Chief Compliance Officers and Chief Legal Officers must seize this unique opportunity to not only avoid the financial, legal, regulatory, and reputational losses that will inevitably follow without an ESG risk management program — but also enhance the value the Risk Team delivers as ESG priorities become pervasive across FIs worldwide. Acknowledging that sustainability and/or ESG professionals are uniquely qualified to provide critical guidance defining and communicating the FI’s objectives, the authors provide a proven framework and methodology for compliance and risk practitioners to leverage as they reach across the aisle to their counterparts in Sustainability or Corporate Social Responsibility to elevate the ESG risk conversation and their own visibility.
Keywords: ESG/environmental social & governance, ESG risks, greenwashing, sustainability, ESG integration, CSR