Fitch says its bank credit ratings covering 940 banks globally are not materially impacted by social or environmental matters because diversification of loan and investment portfolios, combined with insurance, protect banks from financially material potential losses for the 3-5 year horizon of the ratings. Yet the analyses seem to be incomplete or conflicting – giving us something we can all learn from.
- Water is not rated as financially material as credit risk to banks and their holdings. The report provides no specific bank examples of environmental exposures. One note states that Kenyan banks face a higher environmental risk “because the performance of farming loans, which are material for Kenyan banks, is vulnerable to locust plagues, affected by extreme environmental conditions.” However, companies in the western US agriculture industry face meaningful business risk right now due to water shortages. The report offers no insight or explanation as to why western-US farming loans are not rated similarly to those in Kenya. It is possible that the banks evaluated do not have significant interests in drought-affected regions or sectors, although as the ratings cover 940 banks, that seems improbable. However, if that is indeed the case, a disclosure of that point would be valuable context to Fitch’s conclusion.
- Human rights within bank holdings are not rated as financially material to credit ratings. Opening new underserved markets is brought forth as a meaningful social benefit for mortgage issuers and consumer banks, yet nothing is said about existing holdings or commercial/industrial portfolios that face supply chain risks related to human rights matters. While that could imply that the 940 banks covered in report excluded those underwriting loans or investing in industrial sectors, Credit Suisse, Citigroup and FBN Holdings (Nigeria’s third-largest commercial bank) are highlighted in the section on governance.
- In terms of climate risk, the report appropriately differentiates “exposures to higher carbon-intensive industry sectors” from “exposure to environmental impacts – impact of extreme weather events on assets and/or operations” – but neither are considered financially material to bank credit ratings. Interestingly, insurance coverage may be less of a financial mitigation than anticipated even within Fitch’s short time horizon. There are potential specific exclusions in existing coverage and climate-related changes to new/renewing policy terms and conditions may be coming. The insurance industry (where I spent several years of my career) is beginning to take action with regard to climate risk, perhaps none quite like my former colleague Julian Richardson’s Parhelion.
Corporate governance is the only significant material risk in these particular ratings. Probably no surprises here, and it is even the subject of its own recent report from Fitch.
What This Means
When companies report on ESG matters, providing appropriate context, limitations and explanations is important. We can see this from reading the Fitch report, and in Fitch’s views of how they obtain ESG information themselves. They stated they expect the future to bring improvements in environmental reporting that will provide
… greater clarity around emerging environmental risks. This may result in analysts assigning more elevated environmental scores as disclosure around environmental issues increases and becomes more standardised and as regulators begin to consider the introduction of mandatory ratios to highlight the ‘greenness’ of banks’ exposures.
Fitch’s report may simply be intended as a summary, but no such explanation is provided, nor is there a link to more detailed information on bank exposures/ratings on environmental and social risks. Categorizing bank types would be helpful in understanding contrasts in exposures/ratings across different types and providing a sense of how aggregated environmental and social risks may be diluted as a result of the universe of 940 rated entities.
The main takeaway in our opinion is companies producing ESG reports should take care to consider how audiences will interpret and use information – including where audiences may find and interpret gaps and uncertainty. It can be useful to step away from specific reporting framework and think about the content from a layman perspective to find opportunities for improvements.
Beyond just the report, there is also the question of these scores themselves – do they reasonably reflect ESG risks faced by banks? Without clarity of context and more details on Fitch’s methodology, banks and their holdings seem to face more significant environmental and social risk than the scores indicate.