Excerpted from S&P Global Ratings
Environmental, social, and governance (ESG) risks and opportunities can affect an entity’s capacity to meet its financial commitments in many ways.
We recognize ESG is becoming central in most banks’ strategies and topics like climate-change, treating customers fairly, ensuring proper governance and transparency rank high in board’s agendas, likely more than a decade ago. We also recognize that embedding ESG considerations in business settings or risk frameworks is a complex task, which takes time, especially the way banks are looking to support the transition to a carbon-neutral economy.
Large banks have faced, to varying degrees, a significant number of governance-related controversies over the past decade, especially in the aftermath of the great financial crisis but also more recently with potentially large-scale money laundering cases. Those controversies include large fines and other litigation risks due to retail conduct issues or other types of inappropriate behaviour, or inappropriate governance with insufficient control framework (including compliance) or knowledge of risks.
Banks are primarily exposed to environmental and climate risks via their lending and securities portfolios, due to physical and transition risks. Transitioning to a low-carbon economy entails a large set of evolving environmental legislations, norms, and innovations; or changing customer preferences. The EU already announced ambitious objectives for renewables to account for at least 32% in final energy consumption by 2030 and a net-zero carbon target by 2050. Substantial industrial and consumer adjustments will be needed to achieve a 2-degree Celsius scenario. Banks and their clients have to embrace these objectives, or otherwise be exposed to credit, market, operational or liability risks, or simply be disrupted. At this stage, these factors are less directly credit relevant for banks, but the pace of change is rapid.
Assets banks use as collateral, such as properties in the case of mortgage loans, are also at risk of devaluation due to the risk associated with policy transition (evolving isolation, or heating, norms for instance) and rising risks of extreme weather events (such as flooding and water scarcity).
Conduct risk presents a direct social exposure for banks, particularly as regulators are increasingly focused on ensuring that banks are treating customers, predominantly retail ones, fairly and providing value in the financial advice they are giving. Banks face social challenges, including how to avoid reputational or regulatory risks in retail activities, at the time when their commercial practices are under heightened scrutiny in many countries and rising expectations from the population and regulators. Banks need also to carefully manage a transition to a workforce that has a different skill-set than before, and also, being essentially a human capital business model, adapt to the expectations of workers in the new economy. As well, banks are susceptible to data privacy and security–IT breaches, a serious and common threat to the data-intensive industry.
Governance We also form a view of their governance, which is an important component of our assessment of the quality of management and strategy. We look at a number of factors, including the risk appetite and strategy’s stability, the quality of the management team, of the board and the nature of their relationship, the incidence of governance-related controversies and track record of regulatory, tax or legal infractions, the quality of the corporate governance, and the quality and transparency of communication. Some of those issues are systemic and affect the whole industry in a given country. Out of the three factors, governance is by far–and unsurprisingly–the one that influences bank credit quality the most, and most often negatively.
Abu Dhabi Commercial Bank PJSC (ADCB): (A/Stable/A-1) (UAE) (BICRA: 5)
We believe that ESG factors for ADCB are broadly in line with its industry and domestic peers. The Abu Dhabi government holds a 60.2% stake in ADCB and has a significant interest in, and business relationship with, the bank. The emirate appoints the majority of the bank’s board of directors. The government therefore has a strong influence on ADCB’s strategy. In its governance disclosures, the bank sets out its criteria for board member independence, and we believe the governance framework is well-advanced, which we view as positive in this ownership context. Even if UAE’s political institutions are still developing and decision-making processes remain centralized, with some weaknesses in transparency, we believe it has not been detrimental to the bank’s strategic choices or sound business development. High carbon-emitting industries constitute a significant portion of the UAE’s economy and the majority for Abu Dhabi. While we estimate that ADCB has relatively limited direct lending to sectors exposed to energy transition risk, the indirect exposure (via the overall dependence of the UAE economy on hydrocarbons) is higher. We view environmental legislation and norms as less stringent in the UAE than in some European countries or the U.S., which is understandable in an oil-rich economy.
BankMuscat S.A.O.G. (BB/Negative/B) Oman (BICRA: 6)
We view ESG credit factors for BankMuscat as broadly in line with those of industry and domestic peers. The Omani government directly and indirectly owns about 50% of the bank, which helps BankMuscat maintain key account relationships with the government and state enterprises. The stable management team, execution capabilities, and sound governance framework are reflected in our favorable view of BankMuscat’s business position. Solid risk management has also supported the bank’s asset quality, even in a weaker economic environment. In the past few years, BankMuscat has not been involved in any material reputational controversies, has not experienced any incident related to noncompliance with laws and regulations, and has not been subject to any material legal or regulatory fines or settlements. Despite being the flagship bank of a large oil-producing country, we understand that BankMuscat’s direct lending to sectors exposed to energy transition risk is limited (at about 12.5% of total lending). However, the indirect exposure through the potential impact of carbon transition on the Omani economy is higher. Typical in oil-rich countries, environmental legislation and norms are less stringent for corporates than in Europe or the U.S., giving them, and by implication the banks, more time to prepare for energy transition and the gradual move away from fossil energy sources. Social risks are not materially different from those of its industry peers. Omani society is relatively cohesive, but the regional environment is turbulent. Omani banks are not totally immune from the tensions in the Middle East. Aligned with the country’s 2020 vision and as part of its corporate social responsibility, BankMuscat is committed to the hiring and advancement of Omani nationals. The bank maintained an overall Omanization ratio of approximately 95%across its organization in 2019.
First Abu Dhabi Bank (FAB) (AA-/Stable/A-1+) United Arab Emirates (BICRA: 5)
We believe that ESG credit factors for FAB are broadly in line with the bank’s industry and domestic peers. The government of Abu Dhabi has a strong influence on FAB’s strategy and the bank has a privileged relationship with the government and maintains key account relationships with many Abu Dhabi government departments. In this context, the bank maintains a high-quality management team with a solid track record, stability in senior roles, and strong disclosure practices compared with local and regional companies, which we view positively. It sets out its criteria for board member independence in its governance disclosures. Even if the UAE’s political institutions are still developing and decision-making processes (including with regard to GREs) remain centralized, with some weaknesses in transparency, we believe these have not been detrimental to the bank’s strategic choices or sound business development. Carbon-intensive industries constitute a significant portion of the UAE’s economy and the majority of Abu Dhabi’s. We estimate FAB’s direct lending to sectors exposed to energy transition risk to be about 17% of the bank’s total lending at year-end 2018, but the indirect exposure (via the overall dependence of the UAE economy on hydrocarbons) is higher.
Samba Financial Group (SFG) (BBB+/Stable/A-2) Saudi Arabia (BICRA: 4)
ESG credit factors influences SFG’s credit quality similarly to its industry and Saudi peers. The bank has developed a robust governance system with majority of directors being independent and with vast experience in banking industry and regulation. SFG has not been subject to material fines by regulators or subject to any legal settlements. We estimate the direct lending of Samba to sectors exposed to energy transition risk at about 19% of the bank’s total lending at year-end 2018. Indirect exposure is much higher, given the overall dependence of the Saudi economy on oil. Even if environmental legislation and norms are probably less advanced than in Europe and the U.S., Saudi banks will have to adjust to global trends on energy transition and reduce its financing to carbon-intensive sectors. On the social side, the bank follows the Saudization requirements of the Ministry of Labor; about 95% of the bank’s workforce are Saudi nationals, generally on par with domestic peers. We view SFG, like other Saudi banks, as having limited exposure to misselling penalties and other retail conduct risks.