ESG and Risk Assessment: Retail Credit Risk Management

This blog post is part of a series of entries to explore the application of ESG concepts and principles into aspects of Risk Management.

Photo: Finance 2030

 

What is retail credit?

Retail credit is the type of credit provided by banks and other financial services firms to individual borrowers. These types of credit can be in the form of bank loans, mortgages, and home equity loans. Retail loans to an individual borrower are typically of an amount that, if the borrower defaults, does not threaten a bank’s stability. Nonetheless, default rates can change because of changes in the economy and can be systemic.

Can ESG be integrated in retail credit risk management?

ESG is a tough sell for retail credit because of the absence of ESG metrics for individual borrowers and the value of the loans are too inconsequential for lending institutions to spend resources on top of the typical loan diligence measures. Indeed, the use of existing ESG metrics for retail loans may even lead to discrimination against certain groups of people. For example, if credit scores of borrowers living in an area with water shortages are deducated because of such circumstance, it would end up denying capital to the people who need them the most.

Nonetheless, there may be ways to look at credit risk metrics for retail loans in a different light. For example, credit rating scores are the primary tools used by banks to determine a potential borrower’s credit worthiness. A credit score of 700 and above is considered by lenders as desirable, and anything below that carries a higher level of risk. However, one aspect to look at is the trend in a borrower’s credit rating score. Is the borrower’s score improving over time? While the latest score may still be below desired, but the score is showing an upward trend, this indicates improved management of finances and a sense of responsibility by the borrower.

Retail banking is, however, an area of opportunity to apply ESG impact principles and this is being practiced in the US through community banking, and other similar initiatives in developing countries. Banks can consider issuing “green” loans not just to retrofit homes, but also to small businesses that are pursuing mission-driven business lines.

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