From cost to opportunity: The role of ESG in banking

Nitescu, Dan Costin; Ciobanu, Radu; Calin, Adina Elena; Rusu, Ana-Gabriela; Vierescu, Eugen-Marian Article From cost to opportunity: The role of ESG in banking Amfiteatru Economic Provided in Cooperation with: The Bucharest University of Economic Studies Suggested Citation: Nitescu, Dan Costin; Ciobanu, Radu; Calin, Adina Elena; Rusu, Ana-Gabriela; Vierescu, Eugen-Marian (2025) : From cost to opportunity: The role of ESG in banking, Amfiteatru Economic, ISSN 2247-9104, The Bucharest University of Economic Studies, Bucharest, Vol. 27, Iss. 68, pp. 235-252, https://doi.org/10.24818/EA/2025/68/235 This Version is available at: https://hdl.handle.net/10419/318593 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Amfiteatru Economic recommends AE Vol. 27 • No. 68 • February 2025 235 FROM COST TO OPPORTUNITY: THE ROLE OF ESG IN BANKING Dan Costin Nițescu1, Radu Ciobanu2, Adina Elena Călin3* , Ana-Gabriela Rusu4 and Eugen-Marian Vierescu5 1)2)3)4)5) Bucharest University of Economic Studies, Romania Please cite this article as: Nițescu, D.C., Ciobanu, R., Călin, A.E., Rusu, A.G. and Vierescu, E.M., 2025. From Cost to Opportunity: The Role of ESG In Banking. Amfiteatru Economic, 27(68), pp. 235-252. DOI: https://doi.org/10.24818/EA/2025/68/235 Article history Received: 17 September 2024 Revised: 27 November 2024 Accepted: 20 Dece mber 2024 Abstract The multifaceted transformations related to ESG have received many labels, and, in this context, each country has chosen words and actions carefully so as to reflect their strategic interests. But from a financial perspective, ESG should answer the strategic question: is it profitable or not? Integration of ESG in banking requires additional investments, digital transformation, and innovation so as to enhance the sector’s role in achieving sustainability goals. This paper aims to give a new perspective on the profitability related questions linked to ESG implementation. Using panel regression techniques on a sample of 98 banks with global reach and aggregated assets of more than 100 trillion dollars from the major financial centres of the world, we inspect whether ESG disclosure and its individual pillars have an impact on the financial performance of banking organisations. The results reflect that, at a holistic level, ESG tends to negatively influencing banks` financial performance, but considering a detailed view on each of its pillars, the results provide encouraging perspectives for all stakeholders and also lessons to be applied both top-down and bottomup by banking organisations. The article provides a comprehensive understanding of the implications for ESG profitability in the banking sector and emphasises the elements to be considered in finding the balance between cost and opportunity. Keywords: banking, ESG (environmental, social, governance), financial performance JEL Classification: C40, G15, G21, G32 *  Corresponding author, Adina Elena Călin – e-mail: [email protected] This is an Open Access article distributed under the terms of the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. © 2024 The Author(s). AE From Cost to Opportunity: The Role of ESG in Banking 236 Amfiteatru Economic Introduction The multiple crises that emerged during and after the Great Moderation (according to Fed (2013), the period corresponding to mid-1980s to 2007 years) transformed banking organisations in a way that doing business is useless without strong digital competences, especially in the post-global financial crisis years. Besides the complex technological changes, environmental, social and governance principles (ESG) have become an important element both inside and outside the banking sector, producing structural changes in the way banks operate and how they calibrate the long-term business strategies. Given the global objectives of moving towards a more sustainable and resilient economy, the integration of ESG by banks is even more important, with banks' optimal management of ESG influencing the economy both directly, through their own risk management, and indirectly, through the financing of the economy and the activities of their clients. Researchers have found that ESG principles improve companies` performance (Buallay, 2019; Broadstock et al., 2021). Other researchers contend that investment in a durable business could lead to opportunity costs associated with inefficiently allocated capital (Friedman, 1970; Aupperle et al., 1985; Devinney, 2009). In industries with small profit margins, understanding this relationship between sustainability-related factors and firm value could be the difference between profitability and default. Understanding how ESG activity affects bank value is essential because events like the 2008 financial crisis and the LIBOR scandal (and also the march 2023 banking turmoil in US and Switzerland) eroded confidence in financial institutions and illustrate the complacency of both banks and competent authorities (De Larosière et al., 2009; Hurley et al., 2014). The aim of this study is to evaluate whether there is substantial evidence indicating that ESG disclosures and their individual components have a major impact on the financial performance of banks, both from a financial and a market point of view, using panel regression technique on a sample of banks spread globally, during the post-2015 Paris Agreement period. The results highlight that all ESG pillars are important for banks` financial soundness, but the social dimensions emerge as exercising a significant positive influence at all analysed levels and for a large pool of stakeholders. This could be explained by the fact that whether the banking or academic community will label the transition either as “green”, “sustainable” or “clean”, the people, communities and markets are those that, in the end, matter the most and stick the real label. Our analysis contributes to the literature using relevant available data and highlights the main ESG dimensions that affect both negatively and positively the financial performance of banks, while also providing directions for future research. The paper is structured as follows. In the next section, we present the literature review and develop the tested hypotheses. The data description and methodology are given in Section 2, Sections 3 presents the estimates and discusses the results, and Section 4 concludes the paper. Amfiteatru Economic recommends AE Vol. 27 • No. 68 • February 2025 237 1. Review of the scientific literature Banks face increasing pressure from stakeholders and regulators to respond to climate change by reporting their environmental impacts and engage in initiatives to reduce their greenhouse gas emissions (Haque and Ntim, 2020). In responding to this emerging global pressure from stakeholders, banks are more interested in recognising climate change initiatives as means to increase their reputation, promote trust, credibility and improve their performance (Schultz et al., 2013; Dinu V and Bunea M, 2019; Chiaramonte et al., 2022). Gold and Aifuwa (2022) observed that board meetings do not have an impact on bank sustainability reporting and recommends that issues on sustainability to be discussed in corporate board meetings regularly. Adu (2022) finds that sustainable banking initiatives and financial performance are significantly moderated by corporate governance mechanisms and that sustainability performance is mainly positive for banks with quality corporate governance. Despite the importance of board sustainability committees, prior studies exploring their impact on sustainability outcomes have been limited and provided mixed results (Berrone and Gomez-Mejia, 2009; Rodrigue and Cho, 2013; Biswas and Pandey, 2018; Orazalin, 2020; Ionescu-Feleaga, L et al., 2021; Orazalin et al., 2024). Banks with higher emissions have more volatile deposits, leading to volatile return on assets (ROA) and higher bank instability. Banks are expected to maintain high levels of monitoring to provide a trustworthy signal of asset quality to stakeholders. Also, the good reputation is associated with long-term higher profitability and future credit quality (Ross, 2010; Bushman and Wittenberg-Moerman, 2012). Jung et al. (2018) argue that the carbon risk of a firm has a significant impact on its default risk due to the resulting uncertainties in its cash flows. Weber (2014) conducted a study to explore ESG and financial performance in China. Using data from 75 Chinese firms over the period 2005-2012, he found a positive impact of ESG reporting on stock return. Deng and Cheng (2019) examined the impact of ESG rankings on the earnings of Chinese A-Share listed firms using data over the period 2011-2019 and reported a positive connection. They used the ESG rating reports issued by two Chinese rating agencies: SynTao Green Finance ESG rating index and China Alliance of Social Value Investment ESG rating index. The impact was found to be stronger for non-stateowned firms compared to state-owned firms and for firms in the secondary sector compared to those in the tertiary sector. Liu et al. (2021) examined the linear and non-linear impact of ESG financial performance in the Chinese banking sector. Using the data of Chinese banks over the period 2009-2018, they reported a significant positive impact of governance score on return on equity and nominal interest margin profit; however, the composite ESG score, and environmental and social factors did not significantly affect return on assets. Broadstock et al. (2021) found that ESG performance was positively related with the short term cumulative abnormal returns for the period following COVID-19 lockdown and illustrated the resilience of stocks for companies with high ESG performance during the turbulent times of market crisis. Contrary to these findings, Ruan and Liu (2021) found a negative impact of ESG ranking on the performance of China’s Shanghai and Shenzhen listed companies. Their finding was based on the data for nonfinancial firms over the period 2015-2019 with ESG ratings, data using Tobin’s Q as a performance indicator and dependent variable. AE From Cost to Opportunity: The Role of ESG in Banking 238 Amfiteatru Economic Yang et al. (2022) focus on sustainable development goals with sustainable practices followed by different industries in the G7 economies from 2010 to 2018 using panel estimators. For analysing the sustainable practices, ESG pillars were mainly under observation along with the green financing, green economic volatility, and clean energy as key determinants. The findings through the estimation of panel data confirm that ESG indicators play a significant and positive role in sustainable practices. At the same time, with the controlling effect of environmental regulations, foreign investment, and economic growth, the study provides policy implications for the ecological activists and other stakeholders, specifically in G7 economies while creating a linkage between green economy and financing, clean energy and sustainable practices. El Khoury et al. (2021) focus on the banking sector of the Middle East, North Africa and Turkey region while exploring the trends in return on assets, return on equity, Tobin’s Q, and stock returns through ESG indicators for 46 listed banks between 2007-2019. They also control for the bank-specific effect of ESG and quadratic term on financial performance. The findings of their study show a nonlinear association between ESG and the relationship between financial performance. Chouaibi et al. (2021) evaluate ESG businesses and financial performance while investigating the mediating role of green innovation. Data were collected during 2005-2019 for the 115 companies in the UK and 90 companies working in Germany, selected from ESG index. The study findings confirm an increase in the value of those firms having strong ESG reporting compared to those with weak reporting. Furthermore, their findings also provided some interesting practical and academic implications specifically in the context of ESG reporting to leverage some future growth opportunities. Apart from the conventional financial indicators, ESG scores are also critical to evaluate the riskiness of the firm (Apergis et al. 2022). Many credit rating agencies such as Moody’s, SandP, and Fitch rate firms based on their ESG activities. Other studies in the banking sector show a positive role of “sustainable” banking governance practices in reducing the cost of debt financing (Agnese and Giacomini 2023). Firms with better ESG scores exhibit a lower cost of equity (Mulchandani et al. 2022) and have fewer capital constraints. Higher quality and quantity of ESG information benefits the capital markets by enhancing liquidity and lowering the cost of capital for the firm (Christensen et al. 2021). Previous research on ESG criteria primarily focuses on the corporate perspective (Bourcet, 2020; Khanchel et al., 2023; Tsang et al., 2023). However, this review of the literature did not identify any references that support the perspective (the social component of ESG) or address their involvement in organisational management, as highlighted by Ouni et al. (2020). Studies have shown that ESG disclosure has a significant positive impact on financial performance in the European banking sector, including ROA, ROE, and Tobin’s Q (Buallay 2019). In a cross-national study, Lopez-de-Silanes et al. (2020) looked at ESG quality disclosure and found out that companies who perform well on ESG metrics are just being more transparent. According to neoclassical theory, banks will face negative outcomes, such as increased expenses and intense competition, when investing in socially orientated projects (Gholami et al., 2022). Numerous studies have also discovered that, for various reasons that are mostly connected to high operating costs, ESG activities negatively affect bank Amfiteatru Economic recommends AE Vol. 27 • No. 68 • February 2025 239 performance (Crisóstomo et al. 2011; Byun 2018; Duque-Grisales and Aguilera-Caracuel 2021). There are several hypotheses we need to focus on in order to analyse the impact of ESG on banking performance: H1: The combined ESG and ESG pillars are important triggers that can lead to increased bank financial performance. H2: The dimensions of ESG can influence the expected level of bank performance. 2. Research methodology The sustainability discussion is raising the interest of all stakeholders in the financial sector, and banks are pushed forward in the green and climate transition towards a faster and more sustainable growth. But banks do not face the same pressure. This paper aims to provide an updated global perspective on how the transition affects the financial performance of banks from an extended financial area: United States (US), Europe and Asia Pacific countries. In order to capture the multiple-faceted transformations of the banking sector in these areas, we developed the sample of banks using The world's largest banks by assets SandP ranking published on April 30, 2024. Considering the previously mentioned interest geographies, we selected all publicly listed banks with financial and Environmental, Social and Governance (ESG) data available in the Refinitiv and Orbis databases. We chose the Orbis database as it is often used in scientific research for financial data, while the Refinitiv database contains one of the most trusted and comprehensive ESG databases, with several historically available indicators and a clear and transparent methodology. The final sample comprised 98 banking organisations with a global reach and aggregated assets of more than 100 trillion dollars with yearly financial and ESG indicators available for the 2017-2022 period. Table no. 1. Descriptive statistics of key variables ROE ROA SMR TQ NIM ESG Env Soc Gov Mean 0.12 0.01 (0.01) 0.08 0.02 7.36 9.72 8.58 8.44 Median 0.13 0.01 (0.05) 0.06 0.02 7.00 10.00 9.00 9.00 Maximum 0.47 0.06 0.73 1.11 0.22 11.00 12.00 12.00 12.00 Minimum (0.19) (0.01) (0.90) 0.00 (0.00) 3.00 3.00 3.00 2.00 Std. Dev. 0.06 0.01 0.24 0.11 0.02 1.79 2.15 2.15 2.41 For each ESG pillar we used also individual specific dimensions to ensure comparability within the same group variables and ensure the quality of the results: Environmental (E) - reduction in resources, environmental innovation, estimated emissions; Social (S) – product responsibility, workforce, employees; Governance (G) – CEO/chairman duality, board independence, diversity and compensation. The variables used in the analysis are presented in Table 2 and are separated into three categories: AE From Cost to Opportunity: The Role of ESG in Banking 240 Amfiteatru Economic Table no. 2. Variables used in the analysis Variables Labels Explanation Dependent variables Return on equity ROE Measures financial performance and shows a company's ability to generate profits from its shareholders' equity. It is calculated as net income after taxes divided by total equity Return on assets ROA Measures operational performance and shows the profitability of total assets. It is calculated as net income after taxes divided by total assets Stock market returns SMR Market performance indicator and measures the profitability of investments over a specific period. It is calculated as (final price-initial price) divided by initial price Tobin`s Q TQ Measures market performance and is calculated as the ratio of market capitalisation divided by total assets Net interest margin NIM Measures the efficiency of the bank and shows the net return on the bank's earning assets. It is calculated as net interest income divided by average interest-earning assets Independent variables – ESG Combined and ESG pillars ESG Combined ESG Represents the overall score based on the reported information in the environmental, social and governance pillars with an ESG controversies overlay Environmental Env Represents the score based on the reported information in all environmental dimensions Social Soc Represents the information score based on the reported information in all social dimensions Corporate governance quality Gov Represents the score based on the reported information in all corporate governance dimensions Independent variables – ESG dimensions Resource reduction target Env_RRT Reflects the efficiency and capability to reduce the use of natural resources and replace them with more ecofriendly solutions for the operational processes Environmental innovation score Env_IS Reflects the capacity to create new market opportunities by reducing the environmental costs for customers Estimated CO2 emissions (YoY) Env_CO2 Reflects the commitment toward reducing environmental emission in the business processes Product responsibility score Soc_PRS Presents the capacity to integrate customers` health and safety, integrity and privacy in product development Workforce score Soc_WS Measures job satisfaction, employees` health and workplace safety, maintaining diversity and equal opportunities Number of employees (YoY) Soc_NoE Measures the evolution of total employees during a specific period CEO/chairman duality Gov_CCD Reflects the situation in which the same individual serves as both CEO and chairman of the board. We assign 1 if both positions are held by the same person and 0 if they are held by different individuals Amfiteatru Economic recommends AE Vol. 27 • No. 68 • February 2025 241 Variables Labels Explanation Board gender diversity (%) Gov_BGD Reflects the % of females on the board Independent board members (%) Gov_IBM Reflects the percentage of independent board members Board member compensation (log) Gov_BMC Reflects the logarithmic value of the compensation package for board members Banking control variables Capital adequacy ratio CAR Measures the ability to absorb losses and maintain stability during periods of financial stress using the most qualitative equity components. It is calculated as the ratio of Tier 1 Capital at the end of the fiscal year to Total Risk-Weighted Assets Leverage ratio LR Measures the institution’s exposure to the risk of excessive leverage and is calculated as Tier 1 Capital divided by Total Assets Loans to total deposits LtD Measures the proportion of a bank’s loans funded by its customer deposits Macroeconomic control variable GDP growth GDPg Measures how fast an economy is growing We explained each financial performance variable using the definitions provided by the European Banking Authority in its Methodological guidance on risk indicators and analysis tools issued in 2019 and updated in 2023. The ESG indicators are defined using the information available on the Refinitiv website. Banking organisations have known multiple transformative influences since the 2008 global financial crisis, i.e. development of digital banking, pressure from FinTech/BigTech companies, artificial intelligence, more frequent materialisation of non-financial risks. This changing environment poses a threat to the financial performance of banks, which make constant efforts to comply with customers` requirements. As Hughes and Mester (2013) highlighted, there is no consensus among researchers regarding the measurement of financial performance in banking. Therefore, we based our mix of dependent variables on previously reviewed analyses like Azmi et al. (2021), Buallay et al. (2020) and Adu (2022). We developed an extended sample of independent variables as each of these variables would form stronger links with different measures of financial performance. For the G pillar we used four dimensions (CEO/chairman duality, board gender diversity (%), independent board members, board member compensation), unlike the E and S pillars, for which we used three. This difference is justified by governance shortfalls like those from 2023 (Silicon Valley Bank, Silvergate Bank, Signature Bank, First Republic Bank for US market and Credit Suisse European market), by the fact that governance has a critical role in setting the tone of transformation within the banking organisation and that even after the hard lessons of multiple uncertainties, governance and control issues are still most numerous in supervision reports (Fed, 2024). AE From Cost to Opportunity: The Role of ESG in Banking 242 Amfiteatru Economic To further inspect the performance-ESG relationship, we included in our research two types of control variables. Bank specific control variables were used to control for internal bank characteristics that could mislead the relationships and ensure that results reflect the effects of the independent variables rather than the intrinsic factors. The country specific control variables were used given the inter/intra-regional differences in terms economic and technological development, intellectual property regimes, and macroeconomic specificities. To analyse the relationship between banks` financial performance and ESG indicators, we used panel regressions, which are optimal for capturing both cross-sectional and time-series variations, allowing for a more rigorous representation of unobserved heterogeneity across multiple entities and over a longer period of time. The panel regression, either with fixed or random effects, is frequently used in scientific literature, especially on corporate performance in banking. Baltagi (2009) considers that panel data give better results, decrease collinearity among variables and increase efficiency. Hence, panel data provide a better control of the impact of unobserved heterogeneity (Hsiao, 2022). yit=αi+βXit+uit (1) where: yit – the dependent variable for unit i in period t, α – the intercept, β – the vector of coefficients for the independent variables, Xit – the vector of independent variables for unit i and period t, uit – the error term. Panel regressions with random effects permit the assessment of two sources of diversity: between companies for the same year, and within each company over time (Bell and Jones, 2015). On the other hand, panel regressions with fixed effects allow the examination of the within-unit variation, assuming that the intercept is not a random value, meaning each company is significantly different from another in terms of their base levels for the dependent variable. To decide which model is more applicable, we used three tests for model specification in panel data: the Lagrange multiplier (to check if the model needs effects and to verify if they should be applied on cross-section or time series dimensions), the Hausman test (to choose between fixed and random effects) and the likelihood ratio (to determine whether fixed effects are needed). The panel regression tests indicated that cross section fixed effect must be applied on our models. 3. Results and discussion The correlation between variables is presented for ESG pillars and the related dimensions in Tables 3.1 and 3.2. Amfiteatru Economic recommends AE Vol. 27 • No. 68 • February 2025 249 The main limitation in conducting this research is data availability, which is the reason why the number of periods is only 6 years. It is known that there is a gap of minimum one year between the latest financial and ESG data available. 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