Abstract

The recent banks’ failures have highlighted the importance of improving banking sector supervision, emphasizing the need to adopt a holistic approach to risk assessment based on an evaluation of a bank’s business model (BBM) that combines financial (e.g., bank’s balance data) and non-financial information (e.g., bank’s ESG performance). In this study, we explore the joint effect of BBM and their environmental (ENV), social (SOC), and governance (GOV) pillars performance on banks’ riskiness profile. The study uses a sample of 639 EU banks from 2013 to 2022 and applied a random effects model. Our findings suggest wholesale and retail banks could mitigate default risk, enhancing their ENV pillar performance. Differently, investment banks are encouraged to improve their governance best practices and structure to take advantage in terms of riskiness reduction. These results remain consistent after a series of robustness tests, including the 2SLS model and the Arellano coefficient estimation. Our paper offers practical implications for banking supervisory authorities and practitioners, encouraging to adopt a diversified ESG investment strategy according to bank-specific business models.

Introduction

Since the end of the financial crisis, supervisory authorities and policymakers have strengthened banking regulation to assess and monitor the vulnerabilities that have affected the financial system (FSB, 2023). Following these regulatory requirements, the bank business model (BBM) has been a topic of interest in the banking literature to understand better business models characteristics and their divergent impact on performance, efficiency, riskiness, and solvency (BIS, 2022). To stress the importance of business model analysis (BMA), some scholars have shown how business models (BMs) contain information that extends beyond the traditional indicators of bank risk and return, providing regulators and supervisors with better insights into the sustainability of bank profits and stability (Lartey, James, Danso, & Boateng, 2022). Focusing on the risk side, some authors (Marques-Ibanez & Scheicher, 2010) have highlighted how business models can signal a firm’s risk-taking propensity, facilitating incentives to hedge risk.

The recent medium-size banks’ demises (e.g., the SVB bank crisis) have also emphasised the importance of BMA and converging on a compressive evaluation of financial stability. Consequently, supervisory authorities encourage implementing a holistic approach to bank risk assessment to minimize these adverse events and contagion effects in the banking industry (BIS, 2019). Given the evolving market and business environments, supervisors do not look solely at capital adequacy at a single point in time, but rather, they assess BBM viability on longer time horizons.

Indeed, when conducting BMA, supervisors rely on various sources, including banks’ financial reporting; business plans; and internal reporting. BMA is conducted by examining banks’ business environment and dialogues with internal and external stakeholders. In assessing banks’ riskiness, supervisors should consider financial data and non-financial information disclosure (EU, 2014 Non-Financial Reporting Directive – NFRD) to detect risk drivers and crisis determinants not yet investigated in their current analysis models (EU, 2014).

Conclusion, limits, and implications

n this study, we provide empirical evidence concerning the banks’ business models capabilities to differentiate their risk mitigation effect through investment in individual ESG pillars.

Our findings show that regarding the environmental dimension, wholesale banks display a negative association between environmental (ENV) score improvement and default probability. Regulatory responses (EU, 2020) to global environmental challenges further amplify the potential default risks for banking institutions. Although, to a lesser extent, retail banks are also negatively associated with environmental issues. This differentiation arises due to the inherent customer-focused nature of retail banking (Liu & Wan, 2023). As the public’s environmental consciousness increases and regulatory frameworks develop with a concentration on consumer protection, retail banks’ risk profile undergoes slight transformations.

Regarding the social dimension (SOC), investment banks exhibit a strong initial positive relationship, which transitions into a negative one over a longer time horizon. The nature of investment banking activities, characterized by extensive stakeholder interactions and often tied to complex financial ventures, makes them particularly sensitive to social considerations. This susceptibility affects their risk assessments, influenced by social perceptions and stakeholder reputation. Additionally, retail banking, inherently rooted in direct interactions with individual consumers, emerges as exceptionally responsive to social factors. The intricate weave of societal norms, community sentiments, and individual consumer preferences plays a pivotal role in shaping the default risk profile for these banks.