Banking, which is an important pillar in the financial sector, has an important role in sustainable development. Therefore, since sustainability is one of the most vital trends in the banking industry, investors need to ensure sustainable and responsible investing by analyzing corporate social responsibility, corporate governance structures and environmental issues when making investment decisions. This is also due to the fact that sustainability reporting is gaining significant acceptance worldwide as stakeholders feel the need for greater transparency on environmental, social and governance (ESG) issues. Firms’ social, environmental, and governance (ESG) practices are important for all stakeholders.
Therefore, the impact of ESG on firm performance and firm value is a topic of increasing importance in practically. According to neoclassical notion, ESG performance negatively affects financial performance. Based on the neoclassical notion, spending on environmental and social causes relates to a competitive disadvantage and cost increase. The stakeholder notion stated that a firm’s main purpose should be to maximize shareholder value and create value for all stakeholders, such as employees, consumers, and natural or environmental resources. This concept suggests that shifting from shareholder-focused to stakeholder-focused governance would balance the interests of investing and non-investing stakeholders in banks, thereby protecting management’s excessive risk-taking and bank value.
According to the stakeholder and legitimacy principle, a bank’s socially responsible investment positively affects the firm’s performance. In accordance with the stakeholder and resource-based ideas, environmental investment has a positive influence. Based on the agency notion, better corporate governance will improve bank performance since, in the banking industry, better corporate governance disclosures are needed to eliminate conflicts of interest between managers and shareholders and reduce the agency problem . ESG On Banks’ Value Most previous findings investigating the effect of ESG on bank value and performance have assumed that the relationship is linear. However, findings from notional approaches and empirical findings demonstrate that there may not be a linear association between the ESG and bank value. For example, corporate governance provides accountability, compliance, transparency, and decreased agency costs for financial stakeholders.
On the other hand, it is observed that responsible practices such as quality, safety, diversity and equal opportunity in employment, attention to human rights, quality and safety in products and services decrease the firm’s market value. For this reason, the impact of ESG performance on bank value is complex. In addition, managers are willing to invest in socially responsible investments since this can be a strategic tool that brings competitive advantages and increases social welfare. This win-win strategy encourages managers to keep investing in socially responsible investments. However, there may be important risks that arise in practice. Socially responsible investments lead to decreased firms’ resources due to financial allocations, human resources, and managerial inputs. In addition, continuous investment in socially responsible investments can lead to more resource competition between different departments. For this reason, the impact of socially responsible investments on the company’s performance may turn negative after a certain point. Therefore, it may cause a non-linear rather than linear association. But it is prudent and suggested that the costs of ESG investments exceed the benefits in the long term, and therefore the impact of ESG activities on the market performance of banks may be changed.
ESG Pillars’ Effect On Banks Let us to investigate whether ESG and ESG pillar scores affect the bank market value. Study reveals that corporate social performance positively affected the financial performance of banks of 162 banks in 22 countries for 154 financial entities from 22 countries across the world. It has also examined the impact of bank-specific variables and the COVID-19 pandemic on market value. There are several readings on ESG and firm performance, but only a limited number of studies have focused on the banking sector. Also found some findings that the impact of ESG and ESG pillar scores on the market value of commercial banks. Positive relationship was found between corporate environmental and financial performance. Most previous studies found the impact of ESG on bank value and performance have assumed that the relationship is linear.
The bank’s income sources can be divided into interest and non-interest incomes. Interest income includes lending activity such as interest earned from loans and investment securities. Non-interest income covers non-lending activities such as investment banking asset management and insurance underwriting, fee-paying and commission-paying ser- vices, trading and derivatives and other non-interest income activities. Income diversity is the banks’ diversification degree between lending and non-lending activities. Banks must diversify their sources of net operating income between net interest income and non- interest income. A bank is fully diversified when there is a balance between the two types of income. Portfolio diversification would increase the opportunities for overlapping assets, decreasing individual risks and increasing systematic risks. Decreasing individual risks raises the bank values, but increasing systematic risks reduces bank value.
There are bank-specific and external factors that affect the market value of banks. It is needed of a better understanding of the effect of ESG performance on bank market value for investors, managers, regulators and other stakeholders. Developing policies that will make ESG investments more visible and known, such as highlighting them in advertisements, may contribute to increasing the positive effect of ESG on bank value. This is because individuals/foreign investors with environmental and social sensitivity will prefer these banks to purchase services and invest in stocks. It is recommended that the policy makers and regulators provide more support to increase the awareness of all stakeholders and encourage the companies in the environmental, social and management fields. It is empirical evidence that sustainability activities can increase bank value. In addition, it is known that sustainability activities are very important for the survival of the firms and the protection of the ecosystem, and help to improve the social justice and the sustainable economic growth of the countries. For this reason, it is recommended that policy makers develop more robust and holistic policies that are more encouraging in the manner that they regulate sustainability activities of firms/banks.
Concluding Thoughts Of Ways Forward So far time has come to verify whether the effect on bank stability depends on the economic cycle, while controlling for bank- and country-specific variables. History shows, during a financial crisis: (i) banks with higher ESG scores are less risky; (ii) environmental activism reduces bank risk-taking; (iii) bank instability is inversely related to the level of social engagement; (iv) fair governance practices positively affect bank stability; and (v) Non-Financial Reporting Directive rewarded banks more engaged in ESG/CSR practices. Composite ESG score and its individual pillars reduce bank fragility, with a higher impact for the social dimension. Benefits of sustainability practices are contingent on the level of a bank’s engagement in ESG practices, but also on a longer commitment. ESG ratings exert a different impact on stability depending on the characteristics of banks and their operating environments.
However, it is to good extent evident that ESG strategies could act as an insurance-like risk mitigation device for banks during periods of financial distress. A possible explanation is that engaging in environmental, social, and corporate governance practices seems to be associated with more prudent banking activities, fostering more stable relationships with reference communities and enhancing a bank’s reputation. Hence, enhancing ESG engagement in the banking sector is not only beneficial in terms of its impact on the environment and the society but is also able to strengthen the resilience of the banking sector when a financial crisis occurs.
Overall, evidence reveals that beyond the traditional regulatory approach, focusing on ESG issues matters in the banking sector and corroborates the proposal, advancement from Banking Authority, is needed to include ESG considerations within supervisory frameworks. Additionally, integrating sustainability practices into banks’ internal processes to enhance stability should constitute an interesting suggestion also for a sound management of credit institutions. In terms of policy implications, sustainability practices require strong efforts and relatively long periods of time before they provide a benefit on stability. How to improve such benefits or how to extend them to smaller institutions, are open questions for policymakers that should be addressed in future.
END/TMD/ARS
