Last month we discussed environmental, social, and governance (ESG) issues in general and noted that ESG is a topic that commercial banks will be facing. This week, we present a closer look at that topic.

One particular aspect of commercial banking should be mentioned first here. Commercial banks, unlike most other corporations, already have some responsibility to focus on ESG-type issues in the conduct of business. Under the federal Community Reinvestment Act (CRA), banks are subject to meeting the credit needs of the communities in which they conduct business, including low- and moderate-income neighborhoods. Complying with CRA requirements can include not only meeting such credit needs, but also performing other community and charitable works that may have a positive impact on ESG-type issues, especially the social component. Similarly, a bank can address the governance component of ESG, in that the promotion of diversity among board members and management can enhance the bank’s operations and business development. Community banks in particular have frequently sought board diversity because it enhances a bank’s service to the community and thereby benefits business. The foregoing focuses on how a bank may conduct its own operations in light of ESG issues. Regarding the environmental component, however, the business of banking — i.e., accepting deposits, making loans, operating trust departments, and investing in government bonds — does not, by itself, harm the environment.

Nevertheless, banks — both public and private — may be scrutinized by stockholders, customers, and even bank regulators to determine whether they are giving appropriate attention to ESG issues, especially the environmental component. Such scrutiny may focus on a bank’s lending policy: Is the bank lending only upon climate change improvement, or is it considering how a customer, perhaps even a long-term business customer, is promoting (or hindering) ESG issues? The American Bankers Association (ABA) has stated, however, that efforts to use bank regulations to regulate other industries is inappropriate and harmful to the economy, consumers, and the free market.

Assume, for example, that a bank in Louisiana has major customers in the oil business (both onshore and offshore) or that a bank in Alabama has major customers in the coal mining industry (including surface mining). In both cases, the customers produce significant revenue for the banks but in their own business operations are not improving their negative impact on the environment. The bank therefore decides to discontinue lending to such customers unless they agree to modify their operations to promote climate protection or environmental protection in general. Such a change in the bank’s lending policy could chase customers away, resulting in a severe negative impact on the bank’s earnings and capital, and thus could lead to serious regulatory sanctions on the bank. As the ABA says, banks should not be forced “to regulate other industries indirectly.” The ABA has stated that considering banking activities through the ESG lens is “revolutionary.” At the same time, however — as a practical matter and consistent with historical bank lending practices — banks must begin to consider credit and investment portfolio risks associated with such issues, as explained below.

The Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation (FDIC) have published statements relating to climate risks. For example, the FDIC has stated that large financial institutions (those with over $100 billion in consolidated assets) should consider climate-related risk in their operations (see “Statement of Principles for Climate-Related Financial Risk Management for Large Financial Institutions,” March 29, 2022). The FDIC also says, however, that all financial institutions should consider such risks regardless of size. The FDIC opines, in short, that the safety and soundness of a bank may be threatened if the bank does not recognize the “value of property securing financial institutions’ exposures and borrowers’ ability to perform on their obligations.” A borrower may become less competitive over time due to environmental liabilities, and therefore climate-related financial risks for the borrower should be acknowledged­­by the bank when considering credit risk for that borrower. The FDIC has stated, for example, that bank management should consider how a borrower’s disaster-related insurance affects the borrower’s credit worthiness. At the same time, the FDIC also points out that a bank’s consideration in that instance should also include “fair lending concerns if the financial institution’s risk mitigation measures disproportionately affect communities or households on a prohibited basis such as race or ethnicity.”

Thus, in pursuing its lending practices, part of a bank’s due diligence on its customer should include an analysis of whether the customer’s credit consideration involves an analysis of the effect of the customer’s own business operations such as climate control — and whether the customer will suffer financial consequences from governmental penalties, shareholder discontent, third-party litigation, or other risks that make the bank’s loan to the borrower too risky. In short, the statements by bank regulators on consideration of climate-related risks in a bank’s lending policy are a confirmation of the regulators’ position that banks must take into consideration not only the risks sustained by their lending practices but also how those lending practices will be measured on fair lending issues.