Why embedding ESG into probability of default models is good for banks and the planet

From sector-based exclusion to sustainability-linked products, more and more banks are taking steps to align with the growing demand for a more sustainable financial services industry. At the same time, however, the sector is facing growing scrutiny over allegations of ‘greenwashing’ – namely, making a product or service seem more sustainable than it really is, whether intentionally or otherwise. Today, credit providers are under pressure to prove that their practices and portfolios aren’t just papering over the unsustainable cracks in their business models and strategies.

So what can banks do to ensure they’re truly helping to create a more sustainable banking climate – one that supports, encourages, and even incentivizes sustainable business? And, perhaps more importantly, why should they? What’s in it for them?

Enabling a more sustainable society …

One potentially powerful answer to both questions is to factor a customer’s environmental, social, and governance (ESG) performance into the credit-risk decision; specifically, by embedding ESG factors in probability of default (PD) models. Such an approach has several benefits, and several beneficiaries.

First, it would give companies with a higher level of ESG performance more chance of securing credit from traditional banking institutions (as opposed to crowdfunding, for example). Then, these more sustainable businesses would be able to make more of a positive impact through their operations. At the same time, companies with lesser ESG credentials would face less favorable loan terms and conditions, encouraging them to up their sustainability game – and improve their impact on the wider world for the good of people and planet alike.

In turn, of course, promoting sustainable business in this way would help banks capture an important reputational advantage in today’s competitive, sustainability-conscious market. But that’s far from the only reason why credit providers should incorporate ESG metrics into their PD models.

… and ensuring better risk management

The biggest draw for banks is that taking ESG into account in PD analysis can help them better manage their own risk. Traditionally, financial factors have always sat at the heart of credit-risk models like PD – and it makes sense that they always will. But there’s growing evidence that supplementing financial data with ESG metrics is a smart move.

As more and more studies in both the USA and Europe are underlining (download our white paper for more details) as well as a recent EBA Report, a company’s ESG performance can influence its business performance and, therefore, its likelihood of defaulting on a loan. It follows that integrating ESG with PD will help banks build a more holistic and accurate picture of a customer’s credit risk – and act accordingly to reduce their own risk as the loan provider.

More than just a marketing opportunity

More nuanced than sector-based exclusion and less arbitrary than sustainability-linked products, embedding ESG performance data into PD models is a way for banks to contribute to a more sustainable financing landscape over the long term, using quantifiable means that can help them avoid the threat of greenwashing. On a more immediate level, this approach gives banks the opportunity to directly enhance their own performance, by taking a more rounded view of creditworthiness and improving their credit-risk decision-making.

It’s a triple win: for banks, for society, and for our planet. And you don’t have to do it alone: if you want to find out how to get started, read our white paper for the full story – and don’t hesitate to contact our ACE experts to learn how we can help you bridge the ESG–PD gap.

Back to Why embedding ESG into probability of default models is good for banks and the planet