Responsible bank lending: a buzz word or a long-term competitive opportunity?

In the wake of the global financial crisis, the banking sector and its employees have certainly received a lot of criticism (being an ex-banker I have received my fair share as well). So what can the banking sector do to redeem itself and what can it do to avoid another credit bubble in the future? The credit crisis could well tempt banks to take their focus off sustainability for a while but I would argue that the current economic situation offers a unique opportunity to combine long-term risk management with ethical principles and, as a result, drive the future of sustainability as responsible lenders.

Lenders have great power and great responsibility
While the “official” control of a company lies in the voting rights of a company’s shares, let’s not forget the role of the lenders. Lenders could, and often should, have a massive impact on how a business is conducted in the way they grant credit. The term “responsible lending” has become somewhat of a buzz word these days. The term generally tends to refer to ethical consumer lending, which is an area of paramount importance (and a topic for a separate article) but ethical principles in business lending are equally crucial and this is where banks can (and hopefully will) play a key role in the future.

Short-term obstacles but long-term benefits
While banks do their best to highlight their social responsibility publically and progress have been made one should remember that there is still a long way to go.

Perhaps the main obstacle in responsible business lending is that it does not necessarily equate to relatively profitable business in the short term. Relatively irresponsible business customers that have been turned down by other banks might be willing to pay a premium on a loan to a particular bank and might, thus, ironically become a relatively more profitable customer, at least in the short term. Also, adding CSR to the credit process also adds complexity, which means a potentially longer credit and more costly credit process.

The IFC’s equator principles, which were introduced in 2003 in order to promote responsible project finance in the global banking sector (see below for more details) have not always worked that effectively and, as a result, they have not escaped criticism. One controversial example is the the Baku-Tbilisi-Ceyhan pipeline project in 2004 (financed by eight equator principles signatories) when one NGO detected no less than 127 breaches.

The equator principles framework is far from perfect but, despite the criticism, it does present a step in the right direction and the growing number of signatories is very heartening. The principles have already been revised once and one cannot exclude further revisions and enhancements in the future. Also, despite some of the short-term obstacles mentioned above, the long-term benefits for any bank implementing true responsible business lending practices ought to be very lucrative.

First, sustainability is ultimately linked to risk management and better long-term risk management should lead to less credit losses. Thus, it should be in the banks’ own interest to increasingly incorporate CSR issues.

Second, customers focused on energy efficiencies will benefit from cost reductions and become potentially more profitable thereby decreasing the default risk.

Third, a commitment to CSR is an excellent branding opportunity for banks, which can increase customer loyalty. Conversely, banks that are not perceived to behave in socially responsible ways could suffer reputational consequences. True commitment, I believe, will only be powerful and meaningful when a bank appreciates that its long term success is ultimately is linked to its customers’ behaviour.

The IFC’s equator principles: a major step in the right direction
In the wake of the financial crisis the banking industry will most likely become subject to an increased number of rules and regulations. However, there is a lot that the banking industry can do on its own and some has already been done. One such step is the “equator principles”, which were put in place in association with the World Bank’s International Finance Corporation (“IFC”) in 2003 (and revised in 2006).

While the principles were first established years before the credit crisis, it is very positive to see the recent growth in the number of signatories: 84 institutions have signed up at the time of writing – many of which have signed up in 2009. The banks that have signed up represent about 85% of the project finance market and among them you can find some of the largest Australian financial institutions: National Australia Bank, ANZ and Westpac.

So what do the principles mean and how do they apply? There are currently ten equator principles that ensure that a bank makes an informed decision in terms of potential social and environmental risks when granting financing. Please see www.equator-principles.com for full details.

In a nutshell, the equator principles apply to project finance deals over USD10m, which are evaluated against international performance standards covering labour and working conditions, pollution prevention, natural resource management, impact on indigenous people and community health and safety. It should be added that some banks (including ANZ) do not stop at the USD10m limit but apply the principles for all their project finance proposals.

Each bank that adopts the principles declares that it has or will put in place internal policies consistent with the equator principles. One of the equator principles requires public reports on the implementation experiences. Further, the principles stipulate that a bank consults with NGOs and other affected project affected groups for risky projects. The eighth principle concerns covenants linked to compliance. If the borrower fails to comply with the agreed terms, the bank will take corrective action. If unsuccessful this could ultimately result in the bank cancelling the loan and demanding immediate repayment.

What are banks actually doing to implement responsible business lending?
I recently had an interview with the management of a large Scandinavian bank about its responsible business lending practices. This particular bank said it “generally offers credits to all industries as long as the customer is creditworthy and complies with applicable laws, including environmental laws”. While the same bank does refrain from granting loans to companies in certain industries (such as the adult entertainment industry) it does not incorporate corporate social responsibility (“CSR”) in the actual credit process.

Here in Australia, ANZ has specific policies on how to deal with corporate customers in socially and environmentally sensitive sectors (forests, water, mining, minerals, greenhouse and energy policies). According to the bank itself, these policies take into account internationally-recognised social and environmental management standards that the bank will work with its customers to meet and the policies have been developed together with environmental NGOs, governments and industry associations. The policies, which apply to lending and financing, capital raising, equity investments; corporate advisory and capital markets, stipulate that ANZ supports and ensures social and environmental assessments, action plans and management systems. For instance, the Forest policy provides a framework that is comparable with internationally recognised certification schemes and requires all existing customers to prove compliance or a commitment to an agreed plan to comply with the policy.

Practically, ANZ is screening institutional clients by a questionnaire focused on potential social and environmental issues. Clients are rated and those who fail to reach a threshold rating are escalated to senior management. This way all new institutional business clients are screened and existing clients are screened on an annual basis. The assessment becomes the basis for ANZ’s decision whether to proceed with particular client relationship. According to the bank itself, an assessment of the client portfolio shows that about 6% is subject to high social and / or environmental risk (electricity generation, mining, forestry and plastics manufacturing).

It is also encouraging to see that some banks are aiming to become carbon neutral, both through purchasing carbon credits from project that produce renewable energy and internal resource efficiencies. For instance, National Australia Bank aims to become carbon neutral by 2010. Westpac recently issued a five-year plan to reduce emissions by 30%. While these examples have little to do with responsible lending it could hopefully have spill over effects in the form of requirements on other players in the banking value chain; both customers and suppliers.

Banks need to choose which path they want to take
Many market commentators have concluded that we have seen the trough of the recession, or at least that the pace of the slowdown has decreased. Whether they are right or not, the current situation poses a unique opportunity for banks to establish themselves as responsible lenders both to individuals and businesses. The issue of so-called “green washing” makes it difficult to distinguish banks on the basis of their commitment to sustainability today but time will tell. If I was managing a bank I would see sustainability as a great long-term business opportunity!