How to Better Allocate Credit with the help of ESG
On January 3, 2020, the China Banking Regulatory Commission issued the "Guiding Opinions on Promoting the High-quality Development of the Banking and Insurance Industry", which states that “Banking and financial institutions must establish and improve environmental and social risk management and include governance requirements into the entire credit granting process.”
China's financial markets, which are dominated by indirect financing by banking companies, play a key role in allocating credit in line with monetary policy of the day. At present, the scale of China's banking industry is big and continues to grow, but the efficiency between the financial service industry and the real economy is still lacking. These inefficiencies have come about as a result of the structural issues in the supply and quality of financial credit allocation that still does not met the requirements of high-quality economic development.
As we argue in this article, the effective incorporation of ESG factors into the bank credit mechanism could pave a reliable path for better credit allocation and effective supply-side reform in order to achieve high-quality economic and social development in China.
Credit granting mechanism concerning bank credit asset quality and risk management level
(1) Credit asset management
Credit allocation is an important part of the asset business of banking financial institutions. The increasing requirements for capital adequacy have brought challenges to the development of China's banking enterprises. In recent years, banking companies have accelerated the optimization and transformation of their asset structure, continuously increasing the proportion of credit, and strengthened their efforts to support the development of the real economy through credit. According to statistics from the People's Bank of China, in 2019, new loans will still be the driving force for asset growth of large Chinese-funded commercial banks. In November 2019, the loans of large Chinese banks amounted to 72,325,068 million yuan, accounting for 61.28% of the total capital utilization. From the beginning of November 2018 to November 2019, the proportion of various loans in the total use of funds remained was between 59% and 62%.
Figure 1. Month-by-month loan development in 2019 (hundred million RMB), PBOC
However, servicing the real economy through loan channels is a complex system. In recent years, risk exposure incidents have reflected the fact that there are many hidden dangers in the quality of the credit allocated. At present, China's banking industry has a problem of insufficient capital, and a large number of non-performing assets have been generated during the period of economic transition. Therefore, the problem of insufficient capital must be solved by controlling high-risk assets and by improving the quality of assets. According to the official website of the China Banking Regulatory Commission, in the third quarter of 2019, the non-performing loan balance of China's commercial banks was 2.367 trillion yuan, showing an upward trend since the first quarter of 2018. Thus, the credit asset management quality of China's banking enterprises still needs to be further strengthened.
Figure 2. Non performing loan development from 2018 to 3rd quarter 2019, CSRC
(2) Credit risk management
Risk management is key guarantee for a stable operation of the Chinese banks. Banks can only provide stable financing channels for the real economy under the premise of reasonable risk control. China's financial system is dominated by indirect financing, where credit risk is an important part of the risk control. Credit risk exposure, the concentration of loans and advances, concentration of borrowers, the existing five-level classification of loans, are some of the existing control mechanisms that should be strengthened to better control the risks. In recent years, the continuous strengthening of regulatory control measures by regulatory agencies and the risk management mechanism of banking enterprises has gradually improved, while new requirements have been put forward for standards such as loan impairment provisions.
Figure 3. Coverage ratio from 2018 to 3rd quarter 2019, CSRC
Under the China Banking Regulatory Commission's promulgation guidance, revised in 2015 as the “Capital Management Measures for Commercial Banks”, the requirements for strengthening the supervision of loan loss provisions and the loan provision ratio and provision coverage ratio were established. The ratio needs to be above 2.5%, and the provision coverage ratio needs to be above 150%. At the same time, a dynamically adjusted loan loss provision system must be established. As shown in Figure 3, from 2018 to the third quarter of 2019, the provision coverage ratio and loan provision ratio of commercial banks were in line with the provisions of the "Commercial Bank Capital Management Measures", and the loan provision ratio showed bettering. But the provision coverage ratio declined from early 2019 to the third quarter. Facing the current risk environment in the financial market, banking companies need to further improve their credit risk management capabilities and strengthen the risk monitoring of enterprises in key regions and industries.
(3) ESG awareness by banking companies is gradually increasing
The ESG concept is gradually being recognized by investors and enterprises, while awareness of sustainable development of financial institutions has increased significantly. More and more banking institutions are joining the green and sustainability principles, proactively adopting to the international banking sustainable development standards and aligning with international financial development. The Industrial Bank of China has taken the lead by joining the Equator Principles.
In ESG information disclosure, many banks have launched ESG information disclosure systems. Compared with other industries, the average ESG performance of the banking industry is relatively better; in addition, some banks have released ESG-related financial products, such as Hua Xia Bank, which released six in 2019. Based on ESG wealth management products, Suzhou Rural Commercial Bank relies on the ESG assessment methodology of the Green Finance International Research Institute of Central University of Finance and Economics to release the IIGF-Sunon Suzhou Green Development Index and the IIGF-Sunon Yangtze River Delta Integrated Green Development Bond Index. It can be seen that although the current ESG market in China is still in its infancy, in the future, under the joint promotion of supervision and the market, more banks will be ready to participate in ESG investment and ESG management.
The implementation of the ESG-based credit mechanism is a further extension of the banking industry's green development. At present, when banking companies implement the concept of green finance development, they mainly use green credit by issuing and underwriting green bonds. Green credit is currently subject to the "Guidelines on Energy Saving and Emission Reduction Credit" and the "Green Credit Guidelines”. As it stands, the policy requirements of related documents such as Opinions on Green Credit Work are easy to integrate with the bank's traditional credit business, so the scale of development has been expanding in recent years.
Figure 4. Credit balance for green listed banks in 2018 and 2018, 2018 Social responsibility report for listed banks
As shown in Figure 4, of the 48 listed banks in 2019, 35 adopted social responsibility reports for their 2018 and 2017 Green credit balance data in the process of developing green credit business. As shown in Figure 4, according to the nature of the enterprise, 35 listed banks are divided into four types: state-owned banks, joint-stock banks, city commercial banks, and rural commercial banks. Among them, the performance of green credit balance data of state-owned banks is significantly better than other banks. The credit balance reached 739.424 billion yuan, and the ratio of the average value of loans and advances increased in 2017. The performance of joint-stock banks and city commercial banks in this ratio was basically the same as the previous year. The performance of rural commercial banks needs to be improved.
Practical implications of including ESG in the credit mechanism
The three factors of environment, social and governance represented by ESG are important indicators for identifying the credit quality of enterprises and strengthening the risk management of financial institutions. ESG plays a vital role in financial development and "risk prevention and they are a boost for the healthy operation of the country's financial system and the sustainable development of society and the economy. Under the current policy development and market environment, the inclusion of ESG into the credit mechanism has the following practical significance.
First, the adoption of ESG principles can reduce inefficient financial supply and increase effective and efficient financial supply, thereby improving the efficiency of financial resource allocation and smoothing cycle between finance and the real economy, achieving sustainable economic development and preventing financial systemic risks. Financial supply-side reforms provide a new path. The banking industry's inclusion of ESG in the credit granting mechanism is a practical implementation of relevant policies, which meets the current new regulatory requirements.
Second, in recent years, there have been numerous incidents of credit defaults by enterprises due to environmental and social issues, small and micro enterprises in particular, have paid less attention to such risks. ESG is a good representative of the credit quality of the enterprises and can effectively make up for the limitation of the existing financial index evaluation. By incorporating ESG into the entire credit granting process and conducting ESG assessment on enterprises, it can improve the risk identification and early warning capabilities of banking institutions and strengthen the internal risk management systems.
Third, in the context of deepening financial supply-side reform and the establishment of an ESG-based credit mechanism and the establishment of ESG-related standards to evaluate bank credit assets can lead to a reduction in investment in polluting and high-carbon projects, and further help to promote green investment preferences. Meanwhile, these mechanisms can help to select high-quality industries and mobilize and encourage more social capital to invest in high-quality industries, helping to achieve the development of high-quality economic growth.
Fourth, strengthening the disclosure of environmental, social, and governance information in the banking industry and strengthening the interaction with the stakeholders can improve a bank's own governance level. By incorporating ESG into the credit risk management system, corporate customers will be forced to improve their ESG management Level, in return helping in the disclosure of ESG information that is also conducive to the long-term sustainable development of corporate customers.
How to establish an ESG-based bank credit mechanism
(1) Establishing a special ESG management department
At the organizational level, an ESG management department or a dedicated ESG credit committee should be established. In the top-down green financial management system, the extension of green credit combined with environmental, social and corporate governance (ESG) can not be separated from the existing organization. The main responsibilities is on the board of directors, senior management and central management in implementing the "Organization and Management" section of Chapter 2 of the "Green Credit Guidelines" issued by the original CBRC, and the "Guiding Opinions" in the proposal for the establishment of a green sector in the banking industry. Banking companies can set up an ESG management department or a dedicated ESG credit committee, and organize a dedicated team.
(2) Develop an ESG-based credit system
At the policy level, a special credit system based on ESG should be constructed based on its own operating characteristics and development orientation. After the organization is improved, the banking industry needs to further provide ESG-based credit guidelines through the design of the top-level system, improve the overall credit approval and rating classification capabilities, and implement standardized credit management processes. Benchmarking with the “Guidelines for the Performance Evaluation and Supervision of Banking Financial Institutions” issued by the former CBRC in June 2012, that requires banking and financial institutions to set social responsibility indicators in performance evaluation.
In addition, with the ongoing construction of China's market-oriented mechanisms, banking companies will gradually face fiercer competition. Therefore, when formulating the policy system of the ESG credit mechanism, each bank must start from its own operating characteristics and from there develop mechanisms and policies to make a difference.
(3) Inclusion of ESG in the risk early warning mechanism
At the management level, ESG factors should be fully integrated into the three links of pre-due diligence, credit approval during the lending period, and credit management after the credit has been allocated. First, in the due diligence stage, it is necessary to fully understand the ESG risks of the borrower. In this process, it is necessary to conduct a focused investigation on the different ESG risks faced by respective industries. The ESG data channels can be expanded through third-party institutions to form internal ESG rating reports. Secondly, at the credit approval stage, it is necessary to calculate and measure the impact of ESG risk on the overall credit risk, so as to determine the corresponding credit line according to the bank's overall risk management preferences, and set industry limits for ESG high-risk areas. During the post-loan phase, it is necessary to pay attention to whether the borrower has a major ESG risk accident during the implementation period of the loan, and dynamically monitor and establish an ESG risk early warning system, by tracking the loan object in time and adjusting and processing risk assets according to the five-class classification standard of loans.