ESG activities and banking performance: International evidence from emerging economies
Introduction
Shareholder maximization is often stated as the objective of the firm. If this is true, then increased use of Environmental, Social, and Governance (ESG) activities by firms should increase shareholder value.1 However, the empirical evidence of the relationship between ESG activity and firm value is notably inconsistent. Some researchers have found ESG activity improves firm performance (Buallay, 2019; Broadstock et al., 2020). Other researchers argue investment in ESG activity could lead to opportunity costs associated with inefficiently allocated capital (Friedman, 1970; Aupperle et al., 1985; Devinney, 2009). In an industry with small profit margins, understanding his relationship between ESG activity 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 have eroded confidence in financial institutions and illustrate the complacency of both banks and regulators (De Larosière et al., 2009; Hurley et al., 2014). Banks utilize more capital than non-financial firms (Wu and Shen, 2013). If a bank is ineffectually run, it could require a government bailout, which explains the scrutiny of the government, media, and academia (Wu and Shen, 2013). ESG activities provide a potential substitute for these governance structures and could be of value to shareholders, bondholders, depositors, and taxpayers.
We examine the relationship between ESG activities and the financial performance of emerging market banks. Because the banking industry has tight profit margins and is heavily regulated, ESG activities could magnify the differences in competitors' financial performance. However, there are agency costs associated with ESG activity that could affect this relationship (Seifert et al., 2004). The inefficient use of resources for ESG purposes could offset the benefits noted by prior researchers outside the financial sector. By restricting our sample to the banking industry in emerging markets, we reduce the differences in internal and external factors that lead banks to undertake ESG activities (Griffin and Mahon, 1997, Rowley and Berman, 2000, Simpson and Kohers, 2002). The focus on emerging markets allows us to examine banks in markets where regulatory restrictions are low and ESG could provide banks more value.
Using a sample of emerging market banks from 2011 to 2017, we find a non-linear relationship between ESG and corporate performance. Increases in ESG activity improve bank performance. However, ESG activity is beneficial only up to a point, after which there are diminishing marginal returns to ESG activity.
Environmental activities drive our results. The significance of this component is not surprising because awareness of environmental issues has become necessary in the past decade, and people understand that banks play a strategic role in funding projects that can affect environmental change. As investors increasingly recognize the impact of climate change, the signaling benefits of environmental ESG activity is likely to increase. Especially in emerging markets, where air quality and pollution are essential concerns to a bank's stakeholders, activities that positively impact a bank’s environment could be viewed as a commitment to the community.
After establishing the value of ESG activities for emerging market banks, we examine the channels through which ESG affects bank value. We examine three channels: cost of capital, cash flows, and the net interest margin. Although banks engaging in more ESG activity could be more transparent, we find no relationship between ESG activity and the cost of capital. We split the cost of capital into the cost of equity and cost of debt and find environmental activity decreases the cost of equity but does not affect the cost of debt. One possible explanation for these results is that bondholders care primarily about the bank’s tail risk, while shareholders place greater importance on the upside potential of ESG activity.
We note a positive relationship between ESG and both cash flow and the net interest margin of emerging market banks. We posit the positive relationship between ESG and cash flow is due to reduced information asymmetry and greater access to funds. This finding is consistent with Cheng et al. (2014). We hypothesize that depositors are more tolerant of lower interest rates at banks with greater ESG activity. Consistent with this net interest margin channel, banks that invest more in ESG activities are more profitable.
Our paper contributes to the literature in several ways. First, our finding of a non-linear relationship between ESG activity and emerging market bank performance could partially explain the contrasting evidence provided by prior researchers. Our findings support those of Nollet et al., 2016, Sun et al., 2018, who examine non-financial firms and find a similar, non-linear relationship between ESG and firm performance. Our study also addresses the concerns of Brambor et al. (2006), who notes that that the interaction of two continuous variables cannot be interpreted as if they are unconditional marginal effects.2
Second, using emerging market banks is essential because ESG can have the greatest value in emerging markets, where regulations, corporate governance, and transparency are weakest (Khanna and Palepu, 2000). Except for Finger et al., 2018, Broadstock et al., 2020, we are unaware of any study that has examined ESG activities of banks in emerging countries. Unlike Finger et al. (2018), who focus on the effect of Equator Principles (EP) on performance, we investigate the broader use of ESG activity.
Third, our study is also the first to identify the channels through which ESG affects emerging market bank performance. We demonstrate that ESG activity does not affect the cost of debt and only marginally decreases the cost of equity. We demonstrate that ESG activity increases cash flows and improves margins.
Fourth, our paper is the first to document the effects of individual dimensions of ESG on bank value in emerging markets. We demonstrate that environmental activity positively relates to bank value. We find little evidence of a relationship between the social and governance components of our ESG measure and bank value.
We detail our methods and results in the next several sections. In Section 2, we detail our hypothesized relationship between ESG and bank performance. In Section 3, we describe our data and methods. In 4 Results, 5 Robustness, we detail our main results and robustness tests. We provide our conclusions and discuss implications of our findings in Section 6.
Section snippets
Theoretical overview
There are currently two primary theories which predict the relationship between ESG and financial performance: stakeholder theory and trade-off theory. These theories offer contrary predictions, and each is supported by empirical evidence. The resource-based view of the firm and stewardship theory are tangential to stakeholder theory and offer similar predictions. Agency theory offers predictions like those of trade-off theory. We highlight all five perspectives below.
Built on the work of
Explanatory variables
We collect data on 251 banks from 44 emerging markets over the period 2011–2017. We restrict our sample to banks for which we have ESG data in Bloomberg. We also collect country-specific and bank-specific explanatory variables from Bloomberg. We define emerging markets as with low or middle income countries that are becoming more connected with global markets. We restrict our sample to countries defined as emerging markets by Bloomberg.
The Bloomberg terminal provides our ESG data. Bloomberg
Two-step generalized method of moments (GMM)
We use the System Generalized Method of Moments (GMM) method proposed by Blundell and Bond (1998) to control for endogeneity due to omitted variables and has been used in prior studies of emerging market banks to control for endogeneity (Bilgin et al., 2020). This method combines the first differences in our regression equation with the level form. This method reduces any biases and imprecision associated with the first-difference GMM. We use System GMM instead of two-stage least squares
Robustness
In this section, we test the sensitivity of our results to different specifications and methods. We alter our country sample and include additional control variables.
Summary of our findings
In this paper, we examine whether ESG activity of banks in emerging markets affects bank value. We document a non-linear relationship between ESG activity and Tobin’s Q. Low levels of ESG activity positively affect bank value, but high levels of ESG activity exhibit diminishing returns to scale. Our evidence indicates that neither stakeholder theory nor the trade-off theory perfectly explains the relationship between ESG activity and bank value. Rather, some environmental, social or governance
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