Cover Story – Sustainability and Indian Banking System: A Perspective and Way Forward

The structural transformation of India’s economy towards sustainability requires large-scale capital; the banking system plays an important role in funding the transition. Its role becomes important in India, where debt capital is mostly routed through banks instead of the capital market. Particularly, medium and small-sized companies (MSMEs) rely on bank financing for their CAPEX and OPEX funding needs. As banks finance through corporate and project financing routes, sustainable [i] businesses or technologies can raise capital from banks instead of the capital market in the most efficient way.

Globally, several banks have declared to become “net zero” financers by 2050 – it means their lending, operation, and advisory businesses directly or indirectly will not emit any carbon on a net basis. However, only one India Bank, HDFC Bank, has declared any such ambition even if the Government of India has announced to reach net-zero by 2070. Only a single bank signed the Principle of Responsible Banking (PRB), an initiative by The United Nations Environment Programme Finance Initiative (UNEP FI). Only one Indian Bank, HDFC Bank, announced to become net-zero by 2030, but that is only restricted in the Bank’s operation, not in their lending portfolio. Since banks’ direct carbon direct emission is trivial compared to their lending portfolio – their borrowers in the real economy emit carbon. So, banks’ declaration to reach net-zero in their operation will neither help the climate change actions nor make their business resilient against climate change risk. It is another matter that global banks currently have huge carbon-emitting business exposure, and the net-zero target in 2040 and beyond is a long way to go. The declaration could be lip service to shield the wrath from the civil societies and market.

Banking supervisors do not consider sustainability risk

Banks mostly consider sustainability risk at the individual transaction level (Basel Pillar 1) – whether any laws or regulations are violated or will be possibly violated, which can hamper the project’s cash flow generation. However, banks’ existing sustainable risk assessment is mostly related to meeting Government regulation or community challenges rather than the material risk beyond government regulation – which can jeopardize the project’s commercial viability. The incorporation of sustainability risk is missing at Basel Pillar II and III. The banking supervisor in India (RBI) does not consider climate change risk when assessing the overall risk of the banks (Issue Pillar II), and banks do not disclose climate change risk to the market (Pillar III). The current regulation does not cover climate change risk in Pillar II and Pillar III.

Sustainability is missing in the strategy and Governance of banks

Banks have short or medium-term asset and liability duration, unlike institutional investors. They do not consider climate change a material risk in the business operation as they are likely to materialize longer. As the risk is long-term, it is not captured Bank’s business planning and lending operation – a phenomenon Former Governor of England said is a “Tragedy of the Horizon.” Another issue is related to the engagement of the board of directors and top leadership on climate change. Expertise on financial risk related to climate change is missing at the board and top leadership level, which reflects from Indian Bank’s absence from Indian banks in various climate change initiatives and limited disclosure on banks’ strategy or plan in regulatory reports.

Banks cannot ignore climate change risk

Let’s assume banks for a second climate change will not affect banks’ lending portfolio as they are short to medium term (max seven years) while climate change risk will significantly affect in the long term (after ten years). If banks assume this, it is risky because climate change-related events are becoming more severe and frequent every year, e.g., Floods in Mumbai and cyclones in Eastern and Southern India. There is also a tail risk associated with climate change, which may hit the lending portfolio at any time.

Banks also face climate risk on the market side. As banks are currently listed in the foreign stock market (e.g., NYSE, LSE), investors in the foreign market have started considering climate change risk in their investment decision-making. Banks’ significant exposure to carbon-emitting sectors may face the ire of these investors if banks do not incorporate climate change in business planning and lending operation. Similarly, Indian banks also raise debt capital from the foreign market; the cost of debt financing may be higher for banks having substantial loan exposure to carbon-emitting businesses.

Indian banks, as listed in India, do not have to disclose climate-related risk as extensively as international standards (TCFD, for example). There is a possibility they may be forced to follow TCFD for being listed in these stock exchanges as several financial regulators are considering TCFD as a compulsory disclosure standard for listed companies and bond issuers. Indian banks’ heavy exposure to carbon-emitting businesses and lack of intent to decarbonize their lending portfolio may suddenly become a huge market risk in the foreign market and transmitted to the Indian stock market. Any sharp decrease in stock price will consequently affect the cost of funding of banks. The mandatory adoption of BRSR could be a good beginning for banks to gradually move to the International disclosure standard. Still, BRSR is more of stock-taking rather than forward-looking, which is more meaningful considering climate change is going to the businesses in the future.

Way forward

Of course, banks will do start integrating climate change in their Governance, strategy, planning, disclosure, and risk management practices as the regulatory and reputation pressure are mounting. I am focussing on the banks’ lending operations. There are three approaches banks can follow: a. Exclusion of carbon-emitting sectors/companies; b. Integration of climate change in loan pricing; c. Engagement with corporates.

1. Exclusion

Banks can stop lending or refinance heavily carbon-emitting or polluting industries companies. However, this step can help banks reduce climate-related transition risks in their lending portfolio, but not completely. The interlink of companies / or industries and climate-related physical risks (acute and chronic risk) will still expose banks to climate change risk. It is not a smart approach for banks as they may lose a large lending portfolio, interest income, and advisory services related to these companies/industries. As some carbon-emitting companies or industries have significant constituents of the economy, they are the largest customers of banks. Banks can not afford to lose these high-value customers. Besides, several conglomerates, mostly in debt-heavy capital-intensive businesses, denying loans to a single entity may prompt the conglomerate to switch to alternative banks. Banks will lose both fee-based and fund-based income from these conglomerates.

2. Integration of climate change in loan pricing

Banks can absorb climate change risk in calculating loan risk premiums. Banks can charge higher interest rates on loans borrowers exposed to climate change risk and lower interest rates on climate-friendly borrowers. For example, the interest rate can be determined by carbon performance; for example, carbon rating, GHG/Revenue compared to the peers or historically, etc. This incentive mechanism will encourage corporates to decarbonize their business to reduce interest costs.

The key challenge is identifying the material risk factors that differ across companies or industries. Even if banks identify these factors, borrowers are not disclosing enough to measure the exposure and intensity of these risks, which makes it impossible to price these risks appropriately. The disclosure through the BRSR framework should help up to a greater extend. Banks can ask their borrowers to disclose climate-related materials risk factors during the lending assessment process.

Since there is a great distrust among investors and lenders on ESG scoring, banks can develop an internal carbon credit model to calculate credit risks based on companies’ disclosure. Banks can use sophisticated models developed by various institutions and technology companies to identify risks of different industries and companies and assess these risks more correctly, thereby improving banks’ lending processes.

3. Engagement with corporates

Unlike the capital market, banks as a financer are more closed to corporates as they also provide fee-based services. Banks have the opportunity to have and collect more information on corporate behavior, including information related to sustainability. Through this constant engagement, banks can have dialogues and influence corporates to integrate sustainability in their business decision-making. Banks can also share best practices and business models related to sustainability in various industries during this engagement. It is a win-win situation for corporates and banks as sustainability is not a risk but an opportunity to grow businesses.

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[i] I am using sustainability and climate change interchangeably in this article

Disclaimer: “Any views or opinions represented in this blog are personal and belong solely to the author and do not represent views of CFA Society India or those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity, unless explicitly stated.”

About the Author:

Labanya is a Regional Climate Finance Adviser at the Commonwealth Secretariat and Doctoral Scholar at XLRI, Jamshedpur