Monday, March 18, 2013

Basel III and ESG: What's on the table?

Rescue packages and financial regulation remain in the headlines. Seeking to prevent a repeat of the financial crisis of early 2008 onwards, the Basel III requirements have zoomed in on the capital adequacy (capital buffers), leverage ratios and market liquidity (reserves) of banks. Introduced by the Basel Committee's 27 member countries and others as of 2013, Basel III has also expanded the range of risks (credit risk, operational risk, market risk and beyond) addressed. It seeks to promote integrated risk management, which is highly in demand these days.

Basel III raises expectations for improved corporate governance (cf its Principles for Enhancing Corporate Governance, 2010). This includes the ability of board directors to exercise independent judgement, skill and diligence, overseeing management based on fundamental principles, and overseeing transparent reporting. Consumer and investor pressure for improved accountability and transparency will go hand in hand with new expectations for the disclosure of information at global, industry and country level. In its recent analysis of Transparency in Corporate Reporting by the world's largest 105 companies, Transparency International found the 24 financial institutions (including 19 banks) to be the worst performers. This was based on analysis of their reporting on a country-by-country basis, on organisational transparency and on anti-corruption programmes. It sought greater transparency on matters such as corporate structure, including the location of subsidiaries and the levels of revenue, investment and taxes paid by country.

With the Basel III regulations came heated debates about the relative levels of loans, deposits, wholesale debt and equity that banks hold. This reflected, among others, negative public opinion about the relative percentage of earnings based on banking fees charged, interest earned and profits made from trading. New measures to save banks in Cyprus have caused further public outcry in March 2013 as all bank depositors, including smaller account holders with deposits under EUR 100.000, were expected to pay a percentage levy or tax. Arguably the priority should be bank restructuring, which inevitably brings with it losses for major bank creditors (investors) rather than small deposit holders.

The role of equity - bank capital or shareholder capital - that a bank holds is of special interest. At times of economic uncertainty, including risks of more clients failing to do their loan repayments and a bank's investments facing economic downturn, a bank crucially needs equity to fill unexpected gaps. Equity serves to protect deposits and debt from losses. This comes in addition to the protection offered by public deposit insurance systems or guarantee schemes that have especially individual customers and smaller businesses in mind. In the EU such schemes have to cover deposits of up to at least EUR 100.000, a measure to re-assure deposit holders and investor confidence in the European banking system.

How is social responsibility (SR) relevant when considering business or regulatory ratios based on the levels of loans, deposits, wholesale debt and equity that banks hold? To start with, loan-to-deposit (LTD) ratios have in recent times not only raised questions of bank liquidity but also questions about the role of banks in helping economies to grow and recover faster. Surely banks that have benefited from bail-outs need to help economies recover by making it easier and more economical for households and businesses to access lending. Yet many banks hesitate to increase lending before signs of economic growth appear more sustainable. What comes first, lending or growth? Asia may offer important lessons. Moody's reported in early 2013 that LTD ratios in the Asia Pacific range from 70% (Hong Kong) to 140% (New Zealand).

What about return on equity (ROE)? Banks traditionally hold low levels of equity and debt as source of capital. Yet higher level of equity does imply a safer bank. Considering the cushion function of equity mentioned earlier, Basel III is requiring risk-weighted common equity ratios that implies equity-to-asset (ETA) ratios of some 3,5% (see "How much capital did banks opt to hold when they had the choice?" The Economist, 10.11.2012). Higher ratios signal the potential of a more influential role for responsible investors in listed equity. How active are institutional investors committed to the Principles for Responsible Investment (PRI) in engaging banks to advance responsible corporate governance and other ESG factors? Are more sustainable banks rewarded appropriately?

Some encouraging news came last year from a comparative study done for the Global Alliance on Banking for Values (GABV) on the performance of the 29 Globally Systemically Important Financial Institutions (GSIFI - large international banks in Basel terminology) versus that of its 17 smaller-sized member banks during 2007-2010. It found that its values-based banks had an average ETA ratio of over 9% compared to the 5% of GSIFI banks.

Consider also return on assets (e.g. loans, financial instruments, property). More complex to calculate than ROE in the case of banks, return on assets (ROA) is increasingly seen as most relevant for assessing a bank's financial performance. The GABV study found that ROA for sustainable or values-based banks averaged above 0.50% while that of the large GSIFI banks averaged only 0.33%. In addition, their ROE averaged 7.1% compared to 6.6% for the large, mainstream banks. The sustainable banks also increased their lending much more significantly during the 2007-2010 period. When interpreting such findings, one also needs to consider national market context - e.g. that of developed versus emerging markets. While ROE for US commercial banks in 2011 was only around 2%, PWC reported last year that combined ROE for South Africa's largest four banks in 2011 was 15.9%. Relatively smaller, values-based banks in emerging markets could develop into a special breed of their own class.

Will the damaged reputation and slow transformation of large banks cause more consumers and businesses to move their accounts to smaller, possibly more sustainable banks? In the three-pillar banking sector of Germany - comprising savings banks, cooperative banks and private banks - it is the smaller savings and cooperative banks that have weathered the storm that is the financial crisis better. It is them that increased (rather than reduced) their medium- and long-term lending to smaller companies and households. In the UK, the largest five banks have seen stiffer competition from the likes of Triodos ethical bank. The Dutch Triodos has been promoting itself under the banner "Small. The new Big".

This brings us to the alternative, more opportunity-driven ESG agenda as opposed to the risk-driven, Basel III regulatory agenda. It is the preoccupation of some managers in banks, yet one that in the mainstream is still viewed as "non-core". This poses "sustainability strategy" versus "business strategy", a distinction that still applies in most institutions. More on this in the next (Part III) of a three-part series on banking for sustainability.

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