Impact of Environmental Factors on Credit Risk of Commercial Banks

2016-03-19　 作者:ICBC 　

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[Abstract]  The benefits of the positive externalities of an unpolluted environment and stable climate are enjoyed by all economic actors. Conversely, the costs of the negative externalities of the pollution and emissions that damage the environment and cause climate change have historically not affected individual firms. However, both positive and negative externalities can be internalized by a firm with the introduction of relevant policy- and market-based mechanisms. For the first time for a Chinese financial institution, this paper discusses the impact of internalizing environmental costs onto a firm’s balance sheet and the consequent risks this creates for commercial banks. A relevant theoretical framework, transmission mechanisms and analytical methodologies are established to assess the impact of tightening environmental protection standards and climate change policies, joint and several liabilities that banks are exposed to via their customers’ activities and changes in the bank’s reputational standing in the eyes of its shareholders and depositors. Two industries, namely thermal power and cement production, are selected for stress testing against a range of high, medium and low stress scenarios and the impact on their financial performance and credit ratings is assessed as a result. Actionable responses to this analysis are put forward. This bank-led approach to research in this focused field (i.e. assessing the impact of environmental factors on credit risk of commercial banks) is pioneering in China.

 

[Key Words]  Environmental Factors   Credit Risk   Stress Test   Commercial Banks

 

I. Introduction

 

In recent years, a common perspective on environmental risks has developed in the international community; the environmental impact of firms’ operations and their use of natural resources have gone beyond the carrying capacity of the environment, resulting in increasing environmental degradation. As a result, the government, the public and non-governmental organizations have proposed tighter and tighter restrictions on the environmental impact of firms. In turn, this gives rise to a continuous increase in firms’ costs associated with environmental protection policies and a growth in the environmental and social risks that they face.

Consequently, commercial banks or other financial institutions, as the fund providers for firms, are forced to consider more seriously the risks which can result, including the risk of an firm’s failure to repay loans due to the rising costs of complying with environmental protection policies; the risk of assuming joint and several liability for pollution; the legal risk of compensation for damages claimed by third parties; and the reputational risk and risk of losing market share due to non-compliance with new environmental requirements. Most leading international banks have incorporated environmental risk into their risk management systems. In June 2003, 10 international banks including Citigroup, Barclays, ABN Amro and West LB announced their adoption of the Equator Principles, the industry standards developed as the reference point for environmental and social risk management in the project financing activities of commercial banks. ICBC has since formed its own green credit policies, which also use the Equator Principles as a reference point.

After more than 30 years of rapid growth, China is confronted with increasing challenges related to natural resource use and the environment. Nowadays, air, soil and water pollution are all quite severe, which makes the model of extensive economic growth at the cost of natural resources and the environment difficult to sustain. China has therefore attached great importance to the balance between economic development and environmental protection by prioritising “green development” as a national strategy and introducing various relevant policies and regulations in succession (see Table 1).

In order to promote the fast and sound development of green finance, it is pressing for the global banking sector to effectively assess the impact of environmental policy changes, tightening of environmental standards and upgrades to industrial technology on firms’ operating costs. It is also important to take appropriate preventive measures in response to the impact on credit risk of commercial banks based on the aforesaid assessment. This is fundamental to enhancing the holistic risk management practices of Chinese commercial banks, which is of great significance to the sustainable development of China’s banking sector.

In response to increasing environmental risks, ICBC established a research group to study the impact of environmental factors on commercial banks’ credit risks. In this paper, we begin by pointing out that both the positive and negative externalities of an firm’s activities on the climate and the environment can be converted into endogenous variables in the firm’s financial performance by a range of policy, market or legal factors. Secondly, stress testing approaches are used to analyze how the impact of environmental protection policies on firms’ costs could translate into credit risk for commercial banks and how significant that impact on credit risk could be.

The highlights of this paper include:

1. Both transmission mechanisms and quantification methodologies for understanding the impact of environmental policies on credit risks for commercial banks are discussed for the first time by a Chinese financial institution. This provides a market-based mechanism for accelerating efforts to address global climate change. In short, commercial banks can consequently incorporate environmental risks into their credit rating systems for firms based on a quantitative assessment of the impact of environmental factors on firms’ costs. In turn, this affects the cost of capital for firms accessing commercial bank funding, hence promoting green economic development.

2. To deepen the theory of how negative externalities can be internalized on a firm’s balance sheet, and what impact that has on a commercial bank’s risks, a theoretical framework and basic model has been built. This methodology includes the impact of tightening of environmental protection standards and climate change policies, joint and several liability assumed by banks for pollution and reputational risk derived from a bank’s mismanagement of environmental risks in its portfolio.

3. For the first time in China, a “bottom-up” approach (i.e. bank led) has been adopted to conduct a stress test of the impact of the costs of environmental protection policies on two industries (i.e. thermal power and cement) and prove the relevance of, and degree of correlation between, environmental factors and the credit risk of commercial banks.

4. Pioneering research in this focused field (i.e. the impact of environmental factors on the credit risk of banks) has been carried out, measuring and quantifying the impact of environmental risks on firms’ credit ratings, using the unique perspective of stress testing.

The rest of this paper is organized as follows: Section II reviews the existing literature on environmental risk assessment and stress testing from a theoretical perspective; Section III gives a brief introduction to the main concepts underpinning ICBC’s environmental stress testing framework; Section IV takes two industries, thermal power and cement, as examples to estimate firms’ financial performance under stressed scenarios and assess the consequent changes to firms’ credit rating and Probability of Default (PD) using ICBC’s rating model; after that, the relationship between PD and the Non-Performing Loans (NPL) ratio is used to derive the change in the NPL ratio of relevant industries and deduce the variation in credit ratings.

The main findings and conclusions are presented in Section V. Firstly, the impact of environmental factors on the credit risk of banks is calculated on a quantitative basis in order to enhance the bank’s capabilities in environmental risk management; secondly, environmental risk is incorporated into the enterprise credit risk rating system in order to inform the pricing of financial products including credit and investment; thirdly, the basis for reasonable adjustments to the credit arrangements and investment portfolios of banks is provided; fourthly, a reference point for banking regulators to consider the impact of environmental factors on bank risks is provided.

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