This blog post is part of a series of entries to explore the application of ESG concepts and principles into aspects of Risk Management.
What is Commercial Credit?
Commercial credit refers to loans provided to large, corporate borrowers. These loans are typically significant in value that a default could affect the value of a bank’s loan portfolio. Corporate borrowers are subject to more rigid forms of due diligence and are closely examined for their ability to repay their loans.
ESG and Commercial Loan Due Diligence
ESG concepts can be applied when conducting due diligence for corporate loan applications. An analysis of a borrower’s exposure to environmental and social risks, and its management of its risks can complement the traditional analysis of financial statements and balance sheets. For example, an examination of a retail company’s supply chain and labor practices would reveal its exposure to supply chain risks and potential labor issues, both of which could have operational impacts on the company. More importantly, the retailer’s management of supply chain and labor relations would give the borrower an indication of the likelihood of occurrence of supply chain or labor problems and how well prepared it is to manage such problems. High exposure to supply chain and labor issues and poor management may affect a retailer’s ability to sustain its operations and therefore, its ability to repay its debt.
ESG analysis can be applied by the bank during its process of generating the borrower’s Obligor Default Rating (ODR). ESG issues can be integrated as adjustment factors in the ODR process and industry assessment. When assessing the industry where the borrower is classified under, banks can look at the industry’s ESG risk exposure and untapped opportunities and determine where the borrower sits within the industry.
ESG in Commercial Loan Portfolio Analysis
One of the key risks faced by banks is concentration risk or the risk that its loans are concentrated on a single industry whose downturn may result have a significant impact on the bank’s own financial condition. Prudent risk assessment dictates that banks diversify their loan portfolio to avoid concentration risk.
ESG can complement financial factors in a bank’s diversification strategy. A concentration of loans to the oil and gas sector is unsound from both an ESG and financial perspective. The oil and gas sector has a high exposure to a number of ESG risk factors such as carbon, human capital and emissions. A loan portfolio with heavy concentration on this sector is therefore, heavily exposed to climate change risks and labor issues, and potentially vulnerable to large spills and leaks. Diversifying the portfolio to include industries with fewer ESG risks would balance a portfolio’s environmental risk and further reduce its overall risk level.