The future of banking: Towards a more sustainable financial system

Denise De Vor, Jasper De Jong, Danielle Kool

February 2017

On the 24th of January 2017, the president of the United States, Donald Trump, signed an executive order to advance approval of the Dakota Access oil pipelines. The Dakota Access oil pipelines are controversial, because they will contaminate the drinking water of the native Sioux community and 17 million Americans downstream (Jones, Diamond, & Krieg, 2017).

Two Dutch banks, ING and ABN AMRO, have invested $120 million and $45 million in the project, respectively. According to Peter Ras, project leader at the Eerlijke Bankwijzer[1], decent banks should not contribute to controversial projects like this. Instead, they should play an important role in building towards a more sustainable economy (Keuning, 2017). Furthermore, banks need to have a sustainable perspective in order to deal with complex relationships and stay competitive in the future.

In the rest of this blog, we discuss why and how banks can become more sustainable in the (near) future. For the definition of sustainability, we follow the one from the Brundtland Commission. They define sustainability as meeting the needs of the present without compromising the ability of future generations to meet their needs." (Van Gelder

Why should banks be more sustainable?

We identify three main categories in which banks can have an impact on society, both positive and negative. The first is enabling, financing and fostering criminal practices. The concept of 'dirty money' emerged in the 1990s, but it was not until the events at 9/11 that sparked thorough investigation. Anti-money laundering institutions are now also occupied with the investigation of financial flows around terrorist organisations and involved in combatting organised crime and the war on drugs (Favarel-Garrigues, Godefroy, & Lascoume, 2011). Furthermore, the Fair Finance Guide has published various reports on arms trades and financing of weapons (Fair Finance Guide International). Finally, the recent accusation of a Rabobank branch that is allegedly engaged in money laundering of Mexican drugs money shows that these issues are still pressing today and in the future (Van de Water, 2017).

The second means through which banks can have impact is by encouraging their consumers and investments to be green, environmental friendly and socially acceptable. Engaging the financial sector in sustainable development is not new. Already in 1992, the United Nations Environment Programme (UNEP) together with the global financial sector set up the UNEP Finance Initiative to address sustainability issues and create a sustainable financial sector. Today, over 200 financial institutions joined this initiative (United Nations Environment Porgramme - Finance Initiative).

Thirdly, especially since the last economic crisis, ethics play an important role. Bankers do not bear the full costs when investments fail and this remains to be a problem to be tackled. Instead, taxpayers have suffered the losses made by bankers, since defaulting banks expose huge risks to the real economy. Since the last economic crisis, many countries regulated their financial system thoroughly in order to prevent future escalations. Discussions remain about the pros and cons of these measures. Furthermore, these measures are political and may be temporary, as can be observed in the United States, where Trump proposed to amend the constraining regulation such as Basel III and the Dodd-Frank Act on the financial sector in the US (Rushe, 2017).

All in all, despite many initiatives in place, we see them being turned around or insufficient to address current issues. Therefore, we argue in the rest of this blog for a more sustainable banking sector in the (near) future.

What does sustainable banking entail?

In the Collevecchio Declaration, that was launched in 2003, it is outlined what banks should do to make their operations more sustainable. The declaration issupported by over 200 civil society organizations across the world, such as Greenpeace and Milieudefensie. In short, the declaration states six commitments banks should apply to themselves towards more sustainable banking (Van Gelder, 2006). The six commitments are as follows:

1. Commitment to sustainability. Financial institutions should not only focus on profit maximisation, but also engage in social and environmental sustainability. Banks can do so by making ecological limits, social equity and economic justice part of their strategy and core business such that sustainability becomes equally important to profit maximisation and customer satisfaction. In addition, banks should actively try to promote sustainability through the transactions they finance.

2. Commitment to 'do no harm'. Financial institutions should prevent and minimise detrimental impacts of their portfolios and operations on the environment and on society. They can do so by creating policies, procedures and standards based on the Precautionary Principle[2]. In this way they can minimize detrimental impacts on environment and society and improve social and environmental conditions where the institutions and their clients operate. Moreover, transactions that undermine sustainability can be avoided.

3. Commitment to responsibility. Financial institutions should bear full responsibility for the environmental and social impacts of their transactions. Furthermore, financial institutions must pay the costs of the risks they create, including all financial risks and environmental and social costs posed upon the local communities.

4. Commitment to accountability. Financial institutions must be accountable to their stakeholders, especially to those that are affected by activities and companies financed by the institutions. This also means that stakeholders should have a say in financial decisions that have an impact on the quality of their lives and their environment. Formal regulations and procedures within the financial institutions are means to achieve this.

5. Commitment to transparency. Financial institutions must be transparent to all stakeholders. They should do so through standardised, robust disclosure of information and adequate responsive to stakeholder requests for specialised information on policies, procedures and transactions of financial institutions.

6. Commitment to sustainable markets and governance. Financial institutions should ensure that markets are enabled to adhere to sustainability. They can achieve this by actively supporting public policy, regulatory and/or market mechanisms that promote accounting of all costs arising from social and environmental externalities and foster sustainability (Van Gelder, 2006).

In all, it is clear that the transition to more sustainable banking involves a thorough change in the business of banks. One might even call it a transformation. We expect that, in the future, banks cannot choose to operate more sustainably. Instead, it will be become an obligation to become more sustainable because the trends in the financial world and the expectations within society cannot be ignored anymore.

How can we make banks sustainable?

1. Regulatory measures

Another important question that arises is how banks, supervisors, and policymakers need to regulate the financial sector to make sure that financial institutions operate within the boundaries of the law. After the financial crisis of 2007-9, policymakers and supervisors became more aware that sufficient regulation is needed to regulate banks and their operations. Several measures were taken, for example, the Dodd-Frank Act in the United States, and the Third Basel Accord, a framework that is being implemented globally.

In the Dodd-Frank Act, a part is dedicated to the restriction of financial firms to engage in risky investments that do not benefit their customers. Regulation, therefore, needs to stabilize and control the risks and losses of banks on society. Dodd-Frank contributed to higher capital requirements and stricter authorities that seek to minimize risks for both consumers and banks. Also on a global scale, the regulators have agreed upon a set of new regulations, which shows many similarities with Dodd-Frank. The banking crisis in Ireland, Spain, and Greece confirmed too that the failing banks have a negative impact on society and their needs. To limit the risk of failing banks around the world, the Third Basel Accord required banks to implement capital requirements, leverage ratios and stress tests, among others.

The effects of Dodd-Frank and Basel III are still too soon to fully assess, but it seems that parts of the financial system have become more stable by reducing the risks of dangerous products and activities in the system (Baily, Klein, & Schardin, 2017). As can be seen in figure 1, since the implementation of Dodd-Frank capital ratios of U.S. banks have gone up from 8-9% in 2007 to around 14% in 2015.

Figure 1. "Big Six" Average Tier 1 Capital Ratio (Baily, Klein, & Schardin, 2017)

In addition, misleading products are being removed from the market and securities are subject to tighter rules. New authorities and greater transparency in the trade of swaps and derivatives have also strengthened the confidence and protection for consumers. A study by Grill, Lang, and Smith (2015) has shown that there are more incentives for banks to take risks once banks are constrained by a leverage ratio requirement. However, this effect is more than offset by the absorption of the capital buffers, which is beneficial to the stability of banks. The implementations of both Dodd-Frank and Basel III have lead to a stable financial system, although further improvements need to be made in the future.

The environmental concerns in Basel III are, however, insufficiently addressed by bank supervisors. Basel III requires banks to monitor the environmental risks of collateral and to assess whether the borrower is able to repay a loan in case of pollution (University of Cambrdige Institute for Sustainability Leadership & United Nations Environment Programme Finance Initiative, 2014). These rules, however, are not well defined and lack macroprudential regulation for the bank. Hence, a few first steps are required to make environmental regulation for banks better and more effective. Central bankers and supervisors should acknowledge environmental risks and cooperate with banks to allow them to easily adopt environmental regulation. Introducing standards and simplifying rules in the financial sector should encourage banks encouraged to more 'green' lending or investments in 'green' assets. Banking regulation on sustainability can also be combined with stress tests to estimate the risks of sustainable banking.

2. Non-regulatory measures

In addition to official regulation, alternative means can contribute to making the financial sector more sustainable. One is self-regulation, which allows actors within an industry to compose and enforce their own rules. An advantage of self-regulatory systems is increased flexibility and thereby potentially more adequate responses to the issues at hand due to the experiences of the players involved. Nevertheless, critics argue that self-regulation may be inefficient and that players do not necessarily pursue the right interests. According to Omarova (2011) it is implausible to rely on the moral standards of the financial sector and self-regulation should therefore be institutionalized such that the self-regulation can be supervised (Omarova, 2011).

Alternatively, non-governmental organizations (NGOs) play a role in making businesses, governments and consumers aware of what is actually happening and how they can contribute to a more sustainable society. For example, the Fair Finance Guide is an organization initiated by Oxfam that aims to initiate a race to the top by commercial banks regarding social and environmental issues. They developed their own methodology to evaluate banks (Fair Finance Guide International ). Through publishing evidence-based research, they want to inform the public and facilitate critical dialogues. The Dutch version, Bankwijzer, shows for numerous issues to what extent Dutch commercial banks deal with these issues in a sustainable manner (Eerlijke Bankwijzer). Issues that seem relatively under control are human rights, labour rights and corruption. In contrast, topics that raise great concerns are climate change, gender equality, and housing and real estate. In addition, great differences between banks can be observed. For example, Triodos Bank and ASN Bank score well on almost all issues whilst Aegon performs badly (Eerlijke Bankwijzer). Since consumers can easily check this website and see the ratings of the different banks on sustainability, the banks will have an incentive to better adhere to the needs of society.

Conclusion

The events of the financial crisis in 2007-9 heavily shaped the future of banks. Banks have taken large and many risks for their own well being, making society and the environment subordinate to their own profits. Several organizations and institutions have begun to change the role of banks and the impact they have on today's society. Both new measures and regulations are being taken to prevent and reduce the risks of irresponsible bank behaviour. The banking sector needs to be more concerned with society, and has to face and overcome these challenges in the future.


Footnotes

[1] http://eerlijkegeldwijzer.nl/bankwijzer/
[2] http://www.precautionaryprinciple.eu/

References


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