Why do banks need a sustainability strategy?

Under the motto ‘the world united to fight climate change’, 196 states at the 2015 UN climate conference adopted what was named the ‘Paris Agreement’ and created the first legally binding climate protection agreement – a treaty that, for many observers, heralded the beginning of a new era in the fight for the greatest challenge of our time, climate protection. The result is that sustainability is no longer an issue that is merely paid lip service – additional agreements, such as the UN Sustainable Development Goals (SDGs), and the EU Commission’s Green Deal, are cementing countries’ obligation to take action.

The megatrend of sustainability is now the talk of the town. As sustainability tends to do, it will affect all areas of life, such as the environment, social affairs, politics and the economy, and entail long-term structural changes. This issue doesn’t stop at the banking world; it’s going to put the tried and true to the test and create something new.

What’s in store for banks?

In the coming years, the new sustainable finance business sector will become one of the largest areas of growth in banking and will fundamentally change all value creation activities. This will result in a realignment of internal banking strategies and business models, products, processes and banking services. I give a brief summary of exactly what’s in store for banks below.

1. As financial intermediaries, banks are the catalysts for structural change

Europe wants to use what’s known as the Green Deal to become the first climate-neutral continent by 2050. From an economic perspective, this means undergoing a structural transformation that entails restructuring the economy and infrastructure and requires financing. According to EU estimates, the transformation has an annual funding gap of €180 to €250 billion over the next ten years alone.

Financial institutions have an important role to play here: banks, as financial intermediaries, will be held accountable for ensuring the necessary capital flows and channelling them into sustainable projects and funding. This means they act as lenders, secure the flow of capital for infrastructure projects and, at the same time, take charge of channelling cash flows into sustainable investments as required by regulation and legislation. A huge investment market is just now gaining momentum.

A similar dynamic applies to developments on the capital market, as sustainable investments are booming: the global volume of sustainable investments totalled $35.3 trillion in 2020 (Global Sustainable Investment Alliance). This represents a growth of 15 per cent in two years and a total of 36 per cent of all professionally managed financial assets. Additional impressive growth impulses are expected to follow.

For banks that align their business model accordingly, this creates opportunities for additional growth and earning potentials that they can generate in a steadily growing market. Translating this trend into suitable products, offers and financial services will require every area in the bank that adds value to be able to adapt and react quickly. The agility of the process and system landscape, customer processes and the flexibility of product development will be the decisive competitive factors.

2. Banks and EU taxonomy – the regulatory perspective

Experts predict that banks will only be able to maintain their competitiveness in the long term if they align their business model with the signs of the times – in this case, with sustainability criteria. Banks that fail to achieve this metamorphosis are predicted to lose their licence to operate, and their status as financial service providers will therefore become irrelevant to customers.

Don’t confuse this with greenwashing existing services – legislation provides uniform framework conditions and standards that act as strict guidelines for ensuring the efficiency of the transformation. The EU taxonomy for green investments and the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin) directives for handling sustainability risks are clear guidelines that banks must follow. They outline a detailed classification system for all actors in the financial system, with the aim of scaling up investments in environmentally sustainable activities that either serve one of six clearly defined environmental goals or don’t contradict them:

• Climate change mitigation
• Climate change adaptation
• The sustainable use of water and marine resources
• The transition to a circular economy
• Pollution prevention and control
• The protection and restoration of biodiversity and ecosystems

This sees the implementation of the EU taxonomy become mandatory for banks and doesn’t just limit itself to a classification system for sustainable investments. It will be mandatory for banks to publish their sustainability figures and to create a taxonomy report. In doing so, the rules for increasing uniformity and transparency will apply. Conversely, new requirements will be placed on reporting, product development, risk management and IT to ensure compliance in each individual department. A high level of data quality and transparency, as well as efficient IT systems within the reporting system will be provided as hygiene factors.

3. Banks must adapt their risk management processes

Risk management is one of the primary disciplines of finance. The issue of sustainability directly or indirectly influences every risk category in the financial industry. Accordingly, regulations require that financial service providers function as experts at assessing ESG risks (Environmental, Social and Governance), fulfil the BaFin’s binding requirements for handling sustainability risks in risk management and provide information about how they have done so in mandatory audits and reports. Banks are therefore required to adapt their risk management process to include the greatest climate change risks, as well as other environmental and social trends and the effect they have on economic affairs. According to BaFin estimates, the resulting damages could add up to $550 trillion worldwide and represent serious financial risks for regulated entities (banks).

From the banks’ point of view, this will result in an immediate need for action in implementing the ESG requirements to ensure that the risk management systems are interlinked. Existing risk management processes and methods must be put to the test and adapted accordingly.

4. Sustainability from the customer and employee perspective

Social changes are shaping the expectations of customers and employees. Aspects such as a bank’s environmental awareness, climate protection and social responsibility will significantly influence how much trust is put in the institution and how satisfied people are with it. Accordingly, the efforts required for a long-term, environmentally friendly orientation must be able to be recognised as credible and comprehensible. These attributes will strongly influence the attractiveness of a bank as a financial service provider or employer in future.

This requires banks to establish basic structures and processes as regards sustainability and to define concrete measures to ensure credibility. Mere lip service without any discernible effort will prove to be an Achilles’ heel in the competition to keep clientele satisfied and attract talented employees.

Conclusion

Sustainability issues are becoming increasingly important and relevant in banking. Combined with risk management, compliance and new opportunities for revenue and growth, this topic will pervade the banking sector even more in future. How financial institutions orient themselves will also become more important for customers and employees, making it a decisive differentiating factor in competition.

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