5 min read 31 May 22
During 2021, M&G initiated a series of engagements with a number of major banking groups across the three large Latin American banking jurisdictions of Brazil, Mexico and Colombia. The purpose of these engagements was to establish the extent to which these banks conformed with M&G’s ESG priorities, and to push for better ESG disclosure and improvements where we felt this was required. As part of this exercise, we engaged with three banks in Brazil, two in Colombia and one in Mexico.
Debt securities issued by a number of these banks are held, or have previously been held, across M&G’s suite of emerging market bond funds.
Overall, we were pleased with the outcome of the engagements. We felt that management were co-operative and transparent, while treating ESG-related issues as a high priority. However, we identified several key areas where we think improvements could be made. In the sections below, we outline our key findings across each of the three ESG strands.
Please remember that investments in bonds are affected by interest rates, inflation and credit ratings. It is possible that bond issuers will not pay interest or return the capital. All of these events can reduce the value of bonds held by the fund. Investing in emerging markets involves a greater risk of loss due to greater political, tax, economic, foreign exchange, liquidity and regulatory risks, among other factors. There may be difficulties in buying, selling, safekeeping or valuing investments in such countries.
From an environmental perspective, lending practices will clearly be a key focus. In particular, we want to reward lending policies that mitigate environmental risks or encourage cleaner and more ethical activity, whether through reduced emissions or an increased focus on animal welfare. We see bank finance as a key tool in driving positive change in company behaviour and we strive to use our influence to help bring about this change.
While dedicated ESG lending is still relatively small - remaining well below 10% of the loan book for even the leading banks - it is set to rise significantly over the coming years. This is driven not only by the widespread proliferation of new ESG-friendly credit policies, but also by the sharp increase in investor demand for ESG-labelled bonds (such as Green, Social and Sustainable Bonds).
We have written elsewhere about the surge in the issuance of sustainable EM bank bonds. We view this as a positive development, which will help drive further ESG-friendly lending over the coming years. However, it does come with the risk of greenwashing, for example where companies exaggerate the sustainably credentials of their activities.
We remain vigilant to this risk by undertaking extensive due diligence before financing any ESG-labelled bond. This involves a detailed assessment of both the bond’s terms and the alignment of an issuer’s corporate strategy. We will only invest where we have confidence that such instruments are being used to finance sustainable projects and contributing to positive outcomes.
Banks are becoming increasingly focused on the environmental impact of their lending. This is a fairly recent development and clearly a big step in the right direction. The banks we engaged with all have environmental policies either in place or under active development.
However, the robustness of these policies differs. The major Brazilian lenders are leaders in this field, reflecting the need to preserve biodiversity in areas such as the Amazon rainforest. Unusually amongst its peers, one of the participating banks in Brazil boasts an exclusion list, while external consultants are used to independently assess the sustainability of their lending projects. These projects are assigned a rating from A-C, with the majority of one of these Brazilian banks operations achieving an A rating.
At M&G we consider it best practice to be reporting in line with credible bodies, such as TCFD (Task Force on Climate-Related Financial Disclosures) and CDP (Carbon Disclosure Project), to ensure a standardised framework. We were therefore pleased to learn that some banks in Brazil, are incorporating these recommendations.
At the other end of the spectrum are those lenders whose environmental policies require further work and will not be in place until later in 2022. In some cases, this reflects the looser regulatory framework in some countries. Politics is a key driver here, although differing priorities means that some issues that M&G consider to be very important, such as animal welfare, are scarcely addressed at all.
One area to watch will be the reporting standards associated with the surge in new ESG lending. It is not unusual to find banks both willing and able to report on the amount of environmental and/or social lending they undertake. What is harder to gauge is how this feeds into global targets, especially on climate change.
Climate reporting remains quite weak and climate-related lending exclusions are almost non-existent. In the EM space, the former will be easier to remedy than the latter, since many EM countries remain heavily reliant on fossil fuels for their energy needs. However, as long as climate-related reporting standards are sufficiently robust, international investors will at least have the tools they need to maintain pressure on the banks to keep improving. We feel that this should be a particular area of focus for investors and regulators in the coming years.
Financial inclusion is a key focus for M&G, although this is an area where we found a wide dispersion of lending practices. Many of the banks we looked at participate in government-sponsored schemes to help credit reach poorer individuals and micro companies. However, these schemes tend to be relatively small, and banks are often incentivised towards financing better-off people or larger companies since they are inherently less risky. It will take a combination of investor and regulatory pressure to make banks change their behaviour, and we are concerned that these issues are not as high-profile as the environmental ones.
The main tool used by banks to reach poorer segments of society is payroll lending. This is where loan repayments are taken directly out of a borrower’s salary before it is paid, thus limiting the credit risk to the bank. However, these loans are generally only available to individuals with reliable income streams, such as pensioners and government employees, which means that a significant section of society is cut off from this form of finance.
As part of our engagement, we questioned banks on how they were looking to increase credit availability to poorer segments of society. While this is an area which requires further progress, we were encouraged by some of the responses. One of the Brazilian banks surveyed, has committed to lend R$22 billion to small and medium-sized companies run by women to by 2024.
Financial education is critical in helping to prevent the sale of unsuitable products to customers. Banks clearly have an important role to play here, although we felt the responses in this area were largely inadequate. While there are some educational programmes in place, they are not of a sufficient scale. Until this gap is addressed, we feel that stricter regulation will be required to prevent exploitation.
We believe that banks should focus not only on making customers aware of the risks associated with their products, but also to increase the awareness of alternative products which might be more suitable. With this in mind, we were pleased to hear that one of the banks in Colombia has a free ‘Financial Education for Life’ program, which aims to equip younger people with financial tools and concepts. We would also highlight another Brazilian bank, which in 2020 launched eight initiatives to offer financial guidance to clients, as well as supporting people in debt. However, while such schemes are a step in the right direction, we believe a lot more needs to be done to improve financial literacy and this will remain a key area of engagement for us.
Cyber security is an area where we think things look a lot more solid. The use of digital services has expanded significantly since the pandemic, and banks generally now have robust systems in place to protect customers’ privacy and the security of their data. We feel that banks also have effective controls in place to mitigate the risk of selling products online to individuals for whom they would be unsuitable. One area to watch is the increasing use of artificial intelligence and social media for the purposes of online marketing and customer monitoring. However, overall we think digital risks are better managed and understood compared to other social issues.
We feel that governance is perhaps the most important of the ESG strands, since good governance tends to foster a positive corporate culture, ensuring management are well-equipped to mitigate environmental and social risks. Improved bank governance has been a key international policy objective since the Great Financial Crisis (GFC) of 2008. It is therefore no surprise to find that most banks have the key planks of a solid governance structure in place, such as nomination and audit committees and a business-wide code of ethics.
Addressing systemic risks was another key goal of the post-GFC era, so it is also not surprising to find that banks have established strong relationships with regulators. Key risks, such as capitalisation and liquidity, are now kept under constant scrutiny. Transparency has also improved, especially for listed banks, although some privately owned or state-owned institutions can still be nebulous.
Overall, we feel that the banks we looked at had a secure corporate governance structure in place. However, we did note some differences between banks and jurisdictions, and identified some areas where improvements could be made.
For instance, the number of independent directors can vary widely, from a majority in some cases to almost none in others. Furthermore, many Latin American banks are heavily controlled by the state. Clearly, in these situations, investors will rightly question whether decisions are being made commercially or for other reasons. For instance, one of the surveyed banks in Brazil is 50% owned by the Brazilian state, although the bank does have safeguards to prevent the politicisation of its CEO.
There is also a fine line between close co-operation of banks with their regulators and the relationship becoming a little too cosy. It is therefore important to monitor instances of fraud or corruption in connection with a particular bank, since a higher volume could indicate a failure in controls.
Another area that we feel needs improvement is the accountability for ESG goals at senior management level. Many of the banks do not have a board member responsible for ESG policies, and none of them had ESG targets amongst the board’s Key Performance Indicators (KPIs). We think that making ESG goals a higher priority for senior management would help set the right tone across the entire bank. We consider it best practice to have certain senior managers responsible for driving the company’s ESG agenda, which could be further incentivised through linking remuneration with ESG targets. Such governance practices ensure that sustainability is embedded throughout the organisation and that employees are motivated to deliver on their ESG priorities.
Overall we were pleased with the extensive and informative content provided by these Latin American lenders, and it was encouraging to see management taking a keen interest in a broad range of ESG issues. While there were many positives to come out of the engagements, we identified several key areas where we think improvements could be made. These will be our main areas of focus for future engagements.
We shall continue to monitor and to maintain a continuous dialogue with these companies, and look forward to seeing further progress on the areas we have identified in this update.
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