The need for a more socially and environmentally sustainable financial system has never been more crucial than it is at present. Prior studies have considered corporate social responsibility (CSR) as a vital vehicle for achieving sustainable development of the business and the economy as CSR can contribute in several ways. Firms implementing CSR are more profitable due to external factors like enhanced reputation, added market flexibility, and internal factors like innovations; which would lead to sustainable growth. CSR covers six important dimensions –reporting, business ethics and product responsibility, climate and environmental issues, labour issues, community issues, and corporate governance. However, out of those dimensions, presently climate and environmental issues have come out as the single prevalent negative externality of modern times. Experts and policymakers opine those environmental damages are significant threats to financial stability as two types of risk may emerge, namely - transitional risk (due to adjustment process towards a lower-carbon economy), and physical risk (property damages or trade disruption). Further, financing environmentally risky projects can be harmful to a bank’s reputation, which can lead to damage to financial performance, and also to the long-term growth of the bank. Further, as the banks are strongly interlinked; reputation, earnings, and growth have systemic value, and thus any adverse event could severely affect the banking system as a whole through spillover effects. In addition, incentives for short-termism (e.g. CEO compensation) are strongly connected with excessive risk-taking in banks including anti-environmental project financing. Thus, environmental damages could affect the safety and soundness of banks, and also financial stability, and thus increase the systemic risk. Hence, economic activities and welfare suffer greatly.
Furthermore, macroprudential tools have a substantial impact on the systemic risk of banking systems. Consistent with United Nations Environment Programme (UNEP) recommendations to tackle adverse environmental issues, the High-level Expert Group (HLEG) on sustainable finance (established by the European Commission) has put forward the concept of a ‘climate-related financial disclosure’ or a ‘brown-penalising factor’ on banks’ capital requirements. Thus, so far environmental sustainability issues have not yet become a systematic, structured, and integral part of the banking business models and strategies. To strengthen the recommendations of the UNEP, HLEG, and CSIL & UNEP FI , this research has aimed to find empirical support for the explicit acknowledgment and inclusion of environmental risk as an emerging source of systemic risk in the banking system. In attempting so, this research has revealed the impact of the environmental sustainability engagement of banks on four key areas, namely, (1) reputation, (2) earnings quality and growth; (3) incentives for short-termism (e.g. CEO compensation), and (4) systemic risk.
