One of the many legacies of the COVID-19 pandemic is an acceleration of ESG expectations among policymakers and regulators. A key regulatory priority coming out of the crisis will be horizontal business exams to determine whether banks have not only remediated prior supervisory findings but whether they have understood and internalized these findings so that they can ensure effective and sustainable compliance over time.
While prompt and thorough remediation is necessary, it is not sufficient. The banking supervisors expect that well-run institutions will be able to build strong, robust business practices from the start, identify shortcomings and gaps themselves, and then remediate those gaps and shortcomings long before the bank examiners even show up. Supervisors will also assess whether banks are leveraging these “lessons learned” to self-identify and remediate similar issues in other areas of the bank in a timely and thorough manner.
Prioritizing Pandemic-Driven Social Aspects
While the environment, especially climate change, is a critical component of ESG initiatives, financial institutions should not neglect the social component of ESG. Given the social implications of the pandemic, there will be a thorough review of how financial institutions served customers during that difficult time period, with questioning along the following lines:
- Did banks reach out to borrowers proactively?
- What options were available to accountholders lacking digital access?
- What about programs whose intent was to keep businesses afloat, like the Paycheck Protection Program (PPP) program?
- Did a lender’s implementation of the PPP program provide benefits equally, from an access and inclusion perspective?
- Were borrower accommodations offered and serviced in an equitable fashion?
The social component will be an important indicator that will be reviewed carefully relative to the PPP program and borrower accommodations. While the rollout of the program was chaotic and it was challenging to stand up from an administrative perspective, these COVID response programs will be carefully reviewed to determine how inclusively the firm implemented them. It is clear that the incidence of the COVID burden was not equal. It is also clear that the hardest hit businesses and communities often did not receive the greatest benefit from PPP lending.
The social component of ESG also encompasses issues of customer protection, such as privacy and information security, in addition to community reinvestment, fair lending, fair housing, and unfair, deceptive, or abusive acts or practices (UDAAPs). The traditional safety and soundness supervisors will not leave the review of those issues during the pandemic solely to the Consumer Financial Protection Bureau (CFPB). If financial institutions have not already anticipated this, they should initiate their reviews for the questions that will be arising from their safety and soundness supervisors.
The supervisory focus will never be on the share price of the financial institution. The focus will be on access, inclusion, financial soundness, and stability. As a result, if an institution only provided PPP loans to its existing book of business, meaning customers that had previously been vetted from a financial crimes perspective, it may have an inclusion problem.
In contrast, if a bank provided PPP access to non-clients, then it will be important that it followed an appropriate “know your customer” process. An after-action review of activities during the pandemic will occur relative to the PPP program. Reviews will examine dollars borrowed and loans that were forgiven as demand for many of the tranches of the program outstripped the supply. The underlying design and delivery of the PPP program will be reviewed. Some banks did better than others. Scrutiny will be placed on larger banks versus community banks, since the perception is that community banks were better at meeting the needs of rural and underserved groups.
Banks should prepare now and ensure their documentation addresses their program design and implementation during the various phases of the program rollout. As part of that review, careful consideration should be placed on identifying potential fraud in the program, issuing suspicious activity reports (SARs) for those clients where there have been questions, and ensuring that any issues are addressed through documentation. Other COVID relief activities, such as borrower accommodations and fee waivers, should be reviewed through a fair lending lens.
Embodying Corporate Citizenship
Going forward, a practical focus must be taken so that the industry is organically trying to be good citizens and fulfilling the societal obligations that flow from the bank charter and access to federal deposit insurance. Being a good corporate citizen is at the heart of ESG. In the area of governance, the factors creating a robust ESG program are closely aligned with strong risk management practices for financial institutions. Banks should maintain appropriate focus on corporate ethics, corporate culture, and board and senior management responsibilities and leadership. These are key to embodying strong governance as well as meriting a rating of satisfactory or better in the management component of bank examinations.
This need for inward focus is most apparent in the governance component of ESG, but internal operations are also important with respect to environmental and social concerns. In the environmental component, for example, what is the financial institution doing to reduce its own environmental footprint and manage water usage and waste?
In evaluating performance on the social component, banks should look beyond their lending and investing activities and evaluate their performance on other factors, such as workforce management. Does the institution exhibit diversity, equity, and inclusion at all levels? How well are women and people of color represented in leadership, higher-paying jobs, and fields historically held primarily by men?
Taking the Long-Term View
Although accelerated by the experience with pandemic relief programs, driving change through an ESG program still will not happen overnight. As a result, a financial institution will need to take a long-term perspective in terms of its commitment. The ESG vision and strategy of the firm should be focusing on the underpinnings of a good business and expectations associated with robust risk management. Prospective returns should be assessed over years and decades versus quarters. To ensure success, the focus cannot be on quarterly results but long-term impact.
A short-term focus would not satisfy regulatory agencies. Nor would a “check the box” approach or a “what we can do to get by” attitude. Instead, the focus should be on embedding sound risk management into the business underpinnings of the institution. Regulatory agencies want the business to be run well and their focus is on identifying risks and mitigants. Advocates want vigorous ESG programs. Shareholders seek return on capital, while employees seek fair treatment. A well-conceived ESG program can contribute to meeting each of these stakeholders’ expectations.
Editor’s note: Part I of the ESG series, “ESG Isn’t Just PR – It’s the New Frontier in Risk Management,” is available here.
As previously seen in American Banker.