Ethical stance gives bottom-line boost

By Mike Scott. This article originally appeared on FT.com on October 12th, 2006.

The number of banks embracing sustainable banking is on the rise, but what do the banks themselves get out of it?

At first sight, it would seem to be nothing but a drag on earnings. The UK's Co-operative Bank says its ethical policies led it to turn away £10m of business last year, because of concerns over climate change, animal welfare, human rights or the production of problematic chemicals.

However, while Co-Op's stance leads to business being turned away, it says that 34 per cent of its £96.5m pre-tax profit last year can be attributed to its ethical and sustainability policies. Craig Shannon, director of business management, says: "When we launched our ethical stance back in 1992 its initial appeal was very much to individual customers who wanted to know what happened to their money whilst it was in the bank.

"Now, 14 years on, a quarter of the bank's corporate customers join us precisely because we are prepared to turn away certain sorts of business."

The finance sector has a key role to play in making other companies sustainable, says the UK Social Investment Forum. "As sustainable development becomes an ever-greater consumer, political and regulatory concern," it said in a recent report, "financial institutions risk lagging behind their clients and competitors in understanding global environmental and social changes. This may expose investors and financiers to industries in long-term decline and missing out on growth opportunities in financing emerging ones."

HSBC has developed standards for high-risk sectors such as forestry, fresh- water infrastructure and chemicals. If companies do not meet the standards, the bank is unlikely to lend them money, says Francis Sullivan, HSBC adviser on the environment. "We have turned down some very large projects that would have made us a lot of money, either because the project was flawed or because the client lacked the ability to manage the risk involved. Getting involved would have hurt HSBC either financially or reputationally."

A key driver in banks' involvement in sustainablity activities is to minimise their exposure. "The banks are looking for a return on their investment, so they cannot afford too many risks," says Peter Knight, of corporate responsibility consultancy Context. "Environmental and social risks have risen up the agenda and banks are coming under enormous pressure from lobby groups about where they invest."

Banks investing in the Baku-Tblisi-Ceyhan pipeline faced severe criticism from organisations such as Bankwatch, particularly those banks that had signed up to the Equator Principles. Other banks have suffered from their involvement in companies where there has been fraud, as in the WorldCom and Parmalat cases, while conflict of interest issues in research led to multimillion-dollar fines for some of the biggest global banks, including Goldman Sachs, Morgan Stanley and JPMorgan. Poor labour relations, either as a result of outsourcing or redundancy programmes are also a risk.

In an extreme demonstration of the dangers involved, Citigroup was ordered to close its Japanese wealth management arm after an investigation by regulators showed a failure of its internal controls and lack of oversight from its US head office, leading to breaches that allowed "large profits" to be "amassed illegally".

Research shows that high ratings on sustainability factors are a good proxy for high financial performance in banks, says Beth Ambrose, director of research at Innovest Strategic Value Advisors. The reasons for this include:

*Lower levels of bad debts and non-performing loans through more stringent credit risk analysis including social and environmental factors.

*Sticking to the letter and spirit of the law builds a stronger reputation for good behaviour, and reduces fines.

*Supporting brand value and maintaining customer trust.

*HR development - recruitment and retention of the best candidates.

*Foresight and planning to mitigate the risks of operating in emerging markets, including civil society campaigns against poorly managed projects.

"In retail banking, banks with strong Innovest ratings more effectively navigate high levels of UK personal debt, and moreover seem to more effectively capitalise on emerging-market growth opportunities," says says Greg Larkin, Innovest banking analyst.

"We have noticed that almost every company with a low Innovest rating is getting blindsided by unanticipated shocks when they enter emerging markets. Without strong, adaptive systems to anticipate and manage social, governance and environmental risk banks cannot adjust to the risk climate in emerging market economies."

One problem for banks is that if they turn down lucrative work on sustainability grounds, rivals will step in and take the business, says Kirsty Jenkinson, associate director of governance and SRI at F&C. One example of this is loans to Angola's state oil company, Sonangol, which are raising concerns because of fears that these loans lack transparency and that money is being diverted from helping alleviate the country's desperate poverty. "Some banks have refused to get involved, but it is very profitable, so it is a dilemma," says Ms Jenkinson.But, says Karina Litvack, head of governance and SRI at F&C, "in the long run, banks make money by being present in countries where there is a thriving, balanced, prosperous, diverse economy. For that to happen, over time there has to be ever lower levels of corruption, healthy levels of small business in a range of sectors. If you just go for lucrative business in extractive industries, it increases corruption, choking off the development of other sectors. You have to ask yourself whether you want an economy like Angola's or like South Africa's."One factor limiting banks' commitment to sustainability is the lack of research on its benefits. "It is pretty early days for this kind of reporting," says Nick Robins, head of SRI funds at Henderson Global Investors. "We would like to see more about the linkages [between sustainability and profitability]. But there has been a huge change in companies' strategic mindset and the issue is now integral to the way the banks do business."

ABN AMRO is clear that its sustainability stance gives it an advantage in the market place. "In all areas of our business, we are winning new clients who select us because of our sustainability expertise and commitment. These range from retail clients and big charities to major multinationals," says the bank in its latest sustainability report.

Francis Sullivan at HSBC says tools to measure banks' sustainability performance are on the way. "There are increasingly sophisticated measures such as the Dow Jones Sustainability Index and FTSE4Good. It all helps to get companies to compete on sustainability and that is what we are good at - competition."

One perhaps surprising area where sustainability is seen as a real advantage is among emerging-market banks, says Leo Johnson, of Sustainable Finance. "In emerging markets, there is a premium for perceived quality and for corporate governance. Performance in social and environmental governance posts a flag saying: 'We are a quality institution'." One beneficiary of this process is Banca Comerciala Romana, which sold a 62 per cent stake to Austria's Erste Bank for €3.75bn after it was restructured under the guidance of the European Bank for Reconstruction and Development and International Finance Corporation.

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