Understanding environmental, social and governance (ESG) risks and dynamics is an important part of a robust investment process. Global financials offer a clear example of the value of putting ESG analysis in action.
Many investors feel the banking industry’s reputation has been tarnished in recent years following the many high-profile breakdowns in governance and breaches of public trust. At PIMCO, however, we do not believe that these past transgressions should be overwhelming factors in the forward-looking ESG assessment of individual banks, particularly for banks that performed well through the financial crisis or banks that have wholly revamped their management teams and governance processes. We view the much stronger regulatory framework and elevated stature of risk management as significant credit positives, both in terms of the higher capital and liquidity balances now held by most banks and in terms of lower earnings volatility. Although many of the changes have been mandated by regulators, leading banks have fully internalized the new rules and have invested heavily in redefining their culture and the conduct of their employees.
How PIMCO analyzes ESG factors in financials
As PIMCO considers investments in individual banks today, we seek to identify banks that have made significant progress in improving their own culture and conduct in addition to the more tangible improvements in risk management and financial product safety. Our assessments of leadership and governance are paramount, though we also carefully assess each bank’s integration of ESG factors in its underwriting as well as the company’s track record of regulatory compliance and litigation. PIMCO’s stress tests complement regulatory stress test results to provide a view of banks’ internal risk management. We also assess the propensity of company management to reward shareholders versus maintaining a conservative capital cushion in case of a downturn.
We assess each bank against global peers across 11 major ESG factors, detailed below. Our assessment combines both the level and forward-looking trend for each factor into an overall ESG score, which in the case of financials places greater weight on governance and social factors because historically these are the most material risks to the banking industry. By contrast, our ESG scores for energy companies are weighted toward environmental factors.
ESG comparison across global banks
PIMCO assesses ESG factors for major global banks across geographies. Figure 1 shows a summary that provides portfolio managers with high-level insights into the key ESG strengths and weaknesses of major banking systems (recognizing that individual banks’ scores vary). Take the U.S., for example: The Federal Reserve System has created a strong, stable regulatory framework, and its Comprehensive Capital Analysis and Review (CCAR) stress testing process enforces risk management and capital discipline. This supports our stronger view of U.S. banks’ risk management and accounting factors. However, U.S. banks generally have yet to demonstrate lasting improvements in culture and business conduct, and many continue to lag European peers at integrating ESG factors in underwriting and product safety.
Material ESG factors for global banks
In our ESG assessments for banks, we score these 11 factors and compile an overall ESG score weighted according to the impact of each on investments in the banking sector.
Governance (60% of PIMCO ESG score for global banks)
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Culture and business conduct represents a forward-looking view of the bank’s internal business culture and ethical performance. We incorporate select quantitative measures, such as the volume and severity of legal and regulatory settlements, along with more forward-looking inputs, such as the company’s reputation in the marketplace (e.g., does its bankers put client interests first?) and recent controversies (e.g., was senior management held accountable when customers were harmed by unethical practices?).
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Risk management represents our view of management’s risk appetite as well as the company’s capacity to manage those risks over the cycle. We consider how management balances short-term return targets against long-term solvency, how the company’s loan portfolio and loss rates have performed over business cycles, M&A appetite and whether management has set and met achievable targets. It is possible for leading banks to have an aggressive risk appetite as well as a strong risk management and culture.
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Accounting assesses whether the bank’s disclosures are “credible.” We seek to avoid banks and banking systems that delay recognition of bad debts for years or systematically “optimize” risk-weighted assets to report higher capital ratios or enable higher payouts. Our assessments often vary as much by country as by company – e.g., peripheral European countries historically have had weaker accounting rankings than banks in the UK or U.S., where regulations are much more stringent and disclosures more robust and reliable.
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Board effectiveness assesses board leadership, diversity, expertise and track record of replacing underperforming directors. Possible negatives include a combined CEO/Chair role, ongoing regulatory citations or inconsistent strategic focus.
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Human capital assesses the quality of the non-executive employee base by determining how well the company attracts and retains top candidates and provides them excellent training and advancement opportunities.
Social (25% of PIMCO ESG score for global banks)
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Systemic importance assessment does not automatically presume that large, systemically important (“Too Big to Fail”) banks should be viewed negatively. In the post-crisis regulatory environment, the largest banks often offer the greatest protections to creditors due to tighter regulatory scrutiny and higher capital and liquidity standards, even in the context of potential “bail-in” for creditors in a resolution. Systemic importance weighs on our ESG assessment only when the bank’s business activities create negative social externalities, which we do not feel is still the case in the U.S. and throughout most of Europe.
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Financial inclusion and integration of ESG factors in underwriting assesses banks’ commitment to providing financing to underserved market segments in a safe and sound manner (e.g., without exposing themselves to higher losses or potential regulatory fines). While prior infractions are considered, our rating is forward-looking and incorporates an assessment of both the scope of the lending commitment and the company’s management of related risks. For banks with a focus on non-prime consumers, we look critically at the benefits that their products offer to customers rather than focusing only on the profitability to the bank.
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Customer privacy and data security is at present a subjective measure given that few banks provide usable reporting. Until reporting becomes more ubiquitous, we reserve our highest scores for companies that have communicated strategic investments in data security and have had no public data security breaches, while companies that have suffered such incidents score lower.
Environmental (15% of PIMCO ESG score for global banks)
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Sustainable lending impact looks more broadly than simply the static percentage of loans to industries with negative environmental impacts. We also look at underwriting trends, including whether the bank is reducing lending to the coal sector, expanding lending for renewables and whether the bank is involved in controversial projects.
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Environmental impact and sustainability plan assessment includes a discussion of credit risk to the loan portfolio from climate change. The highest-scoring banks have disclosed detailed sustainability targets and made public commitments to reduce greenhouse gas emissions. Extra credit is given to banks that are most active in mapping their lending activities to Sustainable Development Goals (SDGs).
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Green bond issuance gives credit to banks that have been active in issuing “green bonds” – instruments that fund projects with environmental benefits – either as part of their own funding or on behalf of clients.
Integration of ESG analysis into portfolio management
PIMCO credit analysts have assessed over 1,700 parent issuers on ESG performance to date, including over 400 financial issuers. ESG assessments are highlighted in credit research notes alongside our analysts’ internal ratings and investment recommendations. Portfolio managers consider these analyses when evaluating investments for all PIMCO portfolios, in addition to dedicated ESG accounts.
Analysts’ ESG views include narrative assessments and rationales for material factors that have the potential to affect investment performance. Over time, these assessments have been relevant in shaping the investments in our broader portfolios. For example, a generalist portfolio manager may decide to switch between two companies with similar fundamental risk profiles based on their relative ESG value, if the companies are trading at comparable spread levels. Figure 2 illustrates how portfolio managers can separate potential investments into four quadrants based on investment value and ESG value: Invest in issuers trading at attractive valuations and with strong ESG profiles; engage with companies trading at attractive prices, but which have weaker ESG profiles; reduce exposures to companies trading at unattractive valuations despite strong ESG profiles and sell/avoid companies with unattractive valuations and weak ESG profiles.
Key takeaways: many global banks attractive from an ESG perspective
PIMCO incorporates ESG analysis throughout its active investment decision-making process for banks to help ensure that portfolios benefit from a detailed review of significant non-financial factors that have the potential to affect long-term credit performance.
Our latest analysis supports our favorable credit view for leading global commercial banks given the significant regulatory and risk management improvements made since the crisis. Looking ahead, we intend to continue to engage with major banks to encourage ongoing improvements in their sustainability and social lending programs, and we plan to continue to encourage banks to improve the quality of their sustainability disclosures.
PIMCO’s sustainability initiative is dedicated to firmwide integration of ESG (environmental, social and governance) principles, and our investment process emphasizes careful analysis of the broad secular trends at the core of long-term sustainability.
DISCLOSURES
Socially responsible investing is qualitative and subjective by nature, and there is no guarantee that the criteria utilized, or judgment exercised, by PIMCO will reflect the beliefs or values of any one particular investor. Information regarding responsible practices is obtained through voluntary or third-party reporting, which may not be accurate or complete, and PIMCO is dependent on such information to evaluate a company’s commitment to, or implementation of, responsible practices. Socially responsible norms differ by region. There is no assurance that the socially responsible investing strategy and techniques employed will be successful. Past performance is not a guarantee or reliable indicator of future results. All investments contain risk and may lose value. Investors should consult their investment professional prior to making an investment decision.
This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world.
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