Do ESG strategies enhance bank stability during financial turmoil? Evidence from Europe

Abstract

This paper investigates the joint and separate effects of Environmental (E), Social (S), and Governance (G) scores on bank stability. Using a sample of European banks operating in 21 countries over 2005-2017, we find that the total ESG score, as well as its sub-pillars, reduces bank fragility during periods of financial distress. This stabilizing effect holds strongly for banks with higher ESG ratings. These results are confirmed by a differences-in-differences (DID) analysis built around the introduction of the EU 2014 Non-Financial Reporting Directive (NFRD). Our evidence also reveals that, in times of financial turmoil, the longer the duration of ESG disclosures, the greater the benefits on stability. Finally, we show that the ESG-bank stability linkages vary significantly across banks' characteristics and operating environments. Our findings are robust to selection bias and endogeneity concerns. Overall, they support the regulatory effort in requiring an enhanced disclosure of non-financial information.

The Relationship between ESG Scores and Firm-Specific Risk of Eurozone Banks

“…Moreover, ESG contributes to the reputations of companies by creating a moral capital that generates a flow of resources in many forms, such as financial, human, and technological [28]. Increasing interest in the concept of banks has perceived ESG as a tool to increase reputation, trust, and credibility [29]. Since banks have many stakeholder groups, such as depositors, borrowers, stockholders, and the government/public, and are also among the most heavily regulated firms, these theories provide the theoretical basis for ESG studies in banking.…”

“…An increased attention of the stakeholders in the ESG performances of banks is evident, and the adoption of ESG practices has been shown to secure the reputation of banks by minimizing the possibility of sanctions [36]. ESG could be a risk-mitigation tool, especially during periods of financial distress by signaling prudent banking activities, enhancing reputation, and ensuring good relations with the community [29]. These findings suggest that ESG should be considered an effective risk-reducing tool, as it minimizes the idiosyncratic risk through communication with the stakeholders.…”

Is bank risk appetite relevant to bank default in times of Covid-19?

“…To summarize, extant studies investigate bank risk-taking behavior, but the proxy variables used differ largely. Existing research use proxies such as volatility of ROA ( García-Kuhnert et al., 2015 ; Mourouzidou-Damtsa et al., 2019 ), risk assets-to-total assets ratio ( Delis and Kouretas, 2011 ), regulatory capital measured by core capital ratios, total risk-based capital ratios, and equity-to-total asset ratios ( Vodová, 2019 ; Aldasoro et al., 2022 ), credit risk measures such as impaired loan ratios, non-performing loan-to-total asset ratios, and loan loss reserve ratios (see Mio et al., 2022 ), insolvency risk measured by z-scores ( Aljughaiman and Salama, 2019 ; Teixeira et al., 2020 ; Mio et al., 2022 ), the CDS spread ( Drago et al., 2019 ; Di Tommaso and Thornton, 2020 ), and Merton's distance-to-default (DD) ( Chiaramonte et al., 2021 ; García et al., 2022 ; Jo et al., 2022 ).…”

“…Even though z-scores are the common financial metric for insolvency risk, book value rather than market value information is used in calculating z-scores. To complement, the Merton model relies on a market-based approach and is one of the key models to evaluate default risk ( Chiaramonte et al., 2021 ).…”

“…Lastly, the distance-to-default is scaled to determine the expected default probabilities of a bank. One-year-ahead default probabilities data is readily available from the Bloomberg database and is used in a recent study (see Chiaramonte et al., 2021 ).…”