Environmental performance of Swiss banks

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1 Environmental performance of Swiss banks Shifting gears towards next generation banking KPMG Advisory NV WWF Schweiz

2 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 1 Foreword World Wide Fund for Nature (WWF) Climate change is already happening. Businesses and governments need to plan for a warming world. If we embark rapidly on a path of ambitious mitigation, warming can be limited to less than 2 C. If we continue on a path of hesitation and inaction, we are likely to face a catastrophic increase in global temperatures of 4 C or more by the end of the century. Climate change poses a fundamental threat to the global economy, to individual companies and not least, to the financial sector. One of WWF s global priorities is to work towards a climateresilient low-carbon future. If WWF is to succeed in this, we need to engage strongly with the public, with governments and with business - and particularly with the financial sector. WWF engaged with KMPG in the Netherlands to prepare this report to contribute to a better understanding of how environmental challenges impact on business models in banking, and vice versa. Banks with convincing sustainability strategies are better prepared to deal with challenges such as rising energy prices and regulatory changes. This report raises the question however, of whether banks truly understand the environmental risks they face - or if they are passively waiting for governments to act first. The shift to a low-carbon economy and to sustainable supply chains also brings huge opportunities. Whether it is retrofitting existing buildings to meet more demanding energy efficiency targets, or switching to more sustainable standards in agricultural production, the impact on business and on investment flows will be profound. Today, most banks still treat sustainability as a niche question. This means they are ill-equipped to recognise and capitalise on the opportunities related to this transition. However, some banks can and will play a pivotal role in the transition to a low-carbon and more sustainable economy. For banks to fulfil this role they must, as a precondition, systematically understand the environmental challenges and opportunities, and incorporate this understanding into their mainstream business processes. The global financial crisis and the resulting drop in public confidence and trust in the banking sector offer an opportunity for banks to re-think their business models. As they position themselves in an increasingly competitive landscape, Swiss banks should build on the positive reputation of Switzerland as a leader in sustainability. This study shows that several Swiss banks are starting from a strong base of sustainable lending practices. They now need to go beyond this and reap the benefits of becoming true sustainability leaders. KPMG in the Netherlands Businesses today are operating in an ever more interconnected and globalised world. This is also true for financial companies. Financial institutions realise that they are no longer immune from the reputational risks of their clients, and their portfolios are no longer immune from systemic, macro risks such as water scarcity, shortages of natural resources and greenhouse gas emissions. It is in the interests of the banking sector to understand and anticipate the emerging risks and opportunities presented by the changing environment because value is at stake. The degree to which the banking sector has accepted this notion differs from country to country and from institution to institution. In some parts of the world, such as Switzerland, the financial sector has already accepted that doing business goes beyond just managing immediate financial risks and returns. It has accepted that to gain lasting competitive advantage, it must understand a wider set of risks and opportunities. This study into the performance of the Swiss banking sector provides an overview of the current sustainability performance of the industry and identifies examples of leading practice. Even then, it must be considered that leading practice is not necessarily good practice. The report acknowledges that we need nothing less than a paradigm shift in the banking sector to effectively address systemic risks related to the environment. This report cannot provide all the answers to the challenges of sustainability and it does not set out to do so. But we do hope that it will help banks to build business value in a changing world and that it will provide a useful springboard for new thinking, new debate, and above all for the action that will create the next generation bank. Thomas Vellacott CEO WWF Schweiz Barend van Bergen Partner KPMG Advisory NV

3 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 2 Contents Executive summary Introduction 04 Why look at banks? 04 Assessment methodology 05 Participating banks 07 Interviews with subject matter experts 08 Report outline Current situation of Swiss banks 10 ESG performance of Swiss banks by activity 10 ESG performance of Swiss banks by type of bank 11 Conclusions on findings for the current situation of the Swiss banking sector Today s leading practice bank 15 Today s leading practices in banking 15 Today s leading practices in asset management 20 Today s leading practices: Key environmental issues The next generation bank 23 Defining the next generation bank 27 Barriers, roles and responsibilities on the way towards the next generation bank 29 Roadmap towards the next generation bank 32 Conclusions 35 Appendices Appendix A: Assessment framework 37 Appendix B: List of participating banks 38 Appendix C: List of interviewees 39

4 Performance Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 3 Executive summary Banks have the ability to help catalyse the transition towards a more sustainable global economy. This requires a systematic understanding of how macro-risk and more specifically within the context of this study, environmental challenges impact on today s business model of banking. This report is based on an analysis of the environmental, social and corporate governance (ESG) performance of eight Swiss banks, looking at the extent to which they are adjusting their business models and moving towards more sustainable lending and investment practices, with a focus on managing environmental challenges. The assessment methodology applied covers four main areas: the sustainability strategy of the banks, integration of ESG into business activities, product and service offerings and the governance framework. The analysis shows that all of the banks studied have established a set of ESG policies and sustainable product offerings. However, none of them systematically identifies, assesses, controls and monitors ESGrelated risks throughout their business. So far, the banks surveyed have not attempted to monitor their exposure to key environmental issues or their involvement in sustainable alternatives, indicating that these are not considered key reporting requirements. The integration of environmental considerations in mainstream product offerings appears to be minimal. In addition, the banks have generally not developed incentives to reallocate assets to sustainable alternatives. There is no indication however that the Swiss banking sector is lagging behind in an international context, therefore many of these findings will also be relevant in other economies. To assume a change-making role towards a more sustainable global economy, banks need to make the strategic decision to integrate environmental considerations into their mainstream business models. This report explores two hypothetical banks, the leading practice bank and the next generation bank, in order to encourage and facilitate the dialogue on the required next steps and the way forward. Today s leading practice bank is a bank which combines the identified leading practices in the Swiss banking sector. The leading practice bank showcases good practice in the areas of risk management, governance, ESG integration and environmental issues related to water, soft commodities, mining and hydropower. Today s leading practice bank may operate within today s system boundaries but does not necessarily represent the best possible practice and certainly does not trigger the required transition towards a sustainable economic system. It can however serve as a model for banks that are less advanced in this area. The next generation bank is a bank that understands and properly addresses its impact on the environment and society. In doing so it succeeds in managing the material risks and capturing the opportunities provided by a changing business environment. At the same time the bank assumes its role to help bring about the shift towards a more sustainable economy. The next generation bank has been developed as a concept based on the aforementioned analysis, along with interviews conducted with a number of experts. For the next generation bank to become operative however, a fundamental change in the banks approach towards doing business is needed. This report suggests a number of steps which can be taken to address and overcome the main challenges on the road ahead to make that change happen. While the transition to a next generation banking model can only be carried out as a joint effort and with cooperation between different actors, banks have an important role to play in triggering this transition by actively mainstreaming ESG into their core businesses. Multi-actor effort Next Generation Bank Current performance of banks Leading Practice Bank Today s system boundaries Primary actors banks Source: KPMG Advisory NV. Effort

5 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 4 01 Introduction Financial institutions are increasingly aware that not only reputational risk, but also environmental and social risks induced by the activities of their clients, could potentially impact their position and financial wellbeing. Some of these concern macro risks, such as climate change, water scarcity and shortages in natural resources, that affect every sector of the real economy. Besides a natural incentive to manage such risks and identify the opportunities provided by a changing business environment, banks have the ability to influence client behavior through their business models. The aim of the World Wide Fund for Nature (WWF) is to gain insight into the. current sustainability performance of banks, but first and foremost to identify potential areas in which the change-making performance of the financial sector can be enhanced, in collaboration with banks. In order to analyse the current performance of banks, a robust environmental benchmarking framework for the banking sector is required. As such, an initial assessment of banks according to this framework will be a starting point for a continuous dialogue with several market participants on how to enhance the change-making potential of banks. It may also serve as the basis for identifying the leaders and the followers in an increasingly competitive landscape in terms of sustainable financial services, thus raising the bar for responsible policies, business practices and performance. This report addresses the findings of the initial assessment of the Swiss banking sector and challenges the industry by detailing a potential profile for and a roadmap towards the next generation bank, allowing both leaders and followers to take the next steps to improve their change-making performance. Why look at banks? The ability of banks to catalyse the transition towards a low-carbon and more sustainable economy is threefold. In the first place, banks have the ability to directly steer investments towards sustainable sectors and business models and on the other hand they are able to influence the behaviour of clients in less sustainable sectors or operating less sustainable business models. The key driver behind the ability of banks and their motivation to influence client behaviour is their understanding of the risks and business opportunities provided by a changing economic, ecological and social environment and their ability to adjust and develop

6 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 5 services that meet client demand. A consequent transformation of banking and risk models, taking into account environmental, social and corporate governance (ESG) factors could be achieved through a variety of different measures, such as initiatives within the sector or regulatory changes. Collective action may be required to preserve the competitive positions of participants in the process and to systematically understand how environmental risks could be integrated into banking offerings. A second way for banks to exercise influence is by offering specific products and research which stimulate client behaviour and demand. By promoting sustainable alternatives, banks have the ability to pioneer an innovative product offering and influence market perception. These activities of banks are largely driven by the perceived business opportunities. Finally, banks can exercise influence by participating in industry initiatives and international programs, and by endorsing internationally-agreed charters and principles promoting responsible and sustainable investment and lending practices. Such advocacy initiatives are mainly driven by reputational and strategic considerations in view of the growing importance that clients and the general public attribute to the corporate responsibility of banks. Assessment methodology Approach This report is based on an analysis of the ESG performance of eight Swiss banks, looking at the extent to which they apply measures to orient their business models towards more sustainable lending and investment. The aim of the analysis is not to rank the ESG performance of individual Swiss banks, but to gain relevant insight in the current ESG performance of the Swiss banking sector as a whole and to identify and understand leading sustainability practices within the sector. The scope of the analysis includes both the general ESG performance of the banks and their performance on those environmental issues which constitute the areas of expertise and key agenda items of WWF, namely decarbonisation of the economy, water, soft commodities, mining and hydropower. As such, the study emphasises environmental over social and governance factors, usually referred to together as ESG factors. Social and governance factors are however recognised as equally crucial to ensure a long-term sustainable banking business model. The study, which is intended to go beyond policy, assesses the actual implementation of policies and guidelines in mainstream banking activities on a qualitative basis. Where possible, quantitative performance elements are integrated into the assessment framework to measure the extent to which banks are engaged in sustainable lending activities. The analysis is based on publicly-available information and interviews with the individual banks. As the quantitative information proved to be available to a very limited extent only, the results of the assessment reflect the level to which the banks are prepared to deal with ESG issues far more than their actual performance. Throughout this report, when speaking of the performance of banks this should be interpreted accordingly. Study to gain insight in the current ESG performance and leading practices of Swiss banks. Scope of the study limited to general ESG performance with focus on five key environmental issues. Study designed to go beyond policy but results more telling for the preparedness of banks than their actual performance.

7 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 6 The benchmark framework consists of four building blocks: sustainability strategy, integration into business activities, products and services and governance. Assessment framework The assessment methodology can be divided in four major building blocks: Sustainability strategy the sustainability approach/strategy to manage indirect impact i.e. the impact on environmental and social issues, through the banking activities rather than the operational activities; Integration into business activities the level integration of this strategy into business activities, through client and transaction risk analysis processes and actively steering investments towards sustainable alternatives according to ESG aspects; Products and services integration of environmental factors into mainstream product development and specialised sustainable or green products and services to capitalise on market opportunities and decrease portfolio footprint; sub-elements did not relate to the business model of a bank (e.g. adoption of the Equator Principles for banks with no project finance activities), the banks were not assessed on these aspects. When describing the observations in this report, a 100% score merely suggests a maximum score on the applicable scoring table and not necessarily a perfect ESG performance. The framework and the elements for each building block can be found in Appendix A. Governance the overall management framework to manage sustainability risks and opportunities throughout the organisation; Each building block consists of a number of elements related to the main topic of the building block (e.g. environmental and social risk policies form part of the sustainability strategy building block). These elements in turn comprise several sub-elements. The observed performance of the participating banks is assessed against scoring tables for each subelement detailing four model observations ranging from minimal to assumed industry best practice, based on the expert judgment of the authors. All the participating banks are in principle evaluated against the same scoring tables. In cases where the

8 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 7 The business models of banks determine their level of risk exposure and their ability to influence environmental issues. Participating banks Eight Swiss banks were selected for the study on the basis of their size (in terms of balance sheet total) and their relevance in relation to key environmental issues such as decarbonisation, water and soft commodities. The participation of banks in the study was voluntary and the result of a selection and engagement procedure. The participating banks are a combination of global banks, regional & cantonal banks and private banks and as such are assumed to provide a fair representation of the Swiss banking sector. Figure 1 on the following page classifies the banks researched according to their type of business model, the consequences their business models have for their level of risk exposure to environmental issues and their ability to influence environmental issues directly or indirectly. The level of risk exposure is a measure of the exposure of the lending and/or investment portfolios of the banks to environmental issues such as decarbonisation, water, deforestation and biodiversity. The ability to influence refers to the ability of banks to influence the behaviour of clients and to directly steer investments towards sustainable sectors and business models. It therefore captures the potential impact that a bank can have on overcoming environmental challenges and on fostering the transition towards a more sustainable economy. The business model of an individual bank largely influences its position on both axes in figure 1. The banks assessed in the study serve different client groups (e.g. corporate clients versus high net worth individuals), operate in different geographical areas (e.g. cantons versus global presence) and offer different types of financial products and services (e.g. project finance versus asset management services). Consequently, their exposure to environmental issues and their ability to engage on issues like decarbonisation or water differ.

9 Ability to influence Low High Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 8 In the area of project finance for example, banks can exercise a direct influence by adhering to the Equator principles and subsequently enforcing sound environmental risk management processes. In asset management, banks can apply a more indirect approach by introducing ESG criteria and tools to be applied in fund management, however the actual allocation of funds and ultimate investment mandates are decided upon by clients. Interviews with subject matter experts Over the period July to October 2012, interviews were conduct with independent third party subject matter experts discussing the conclusions of the assessment of the change-making performance of the Swiss banking sector and the view of the experts on how the next generation bank will look. The experts were selected from the banking environment and academia, based on their expertise regarding banking, regulatory frameworks or sustainability and preferably combinations of these fields of interest. These interviews have been used to support the report findings and to shape the profile of and roadmap towards the next generation bank. A full list of the experts interviewed can be found in Appendix B. Figure 1: HIGH EXPOSURE- ABILITY MEDIUM EXPOSURE-ABILITY LOW EXPOSURE- ABILITY Global banks Regional & Cantonal banks Private banks Low Level of risk exposure to environmental issues High Source: KPMG Advisory NV.

10 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 9 Report outline The analysis of the Swiss banking sector has led to the identification of existing sustainable industry best practices for each of the following areas: sustainability strategy, integration into business activities, products and services, governance, key environmental issues. These topics are explained in more detail in chapter 2. By combining all the identified leading practices from different Swiss banks, a leading practice bank has been conceived, which is described in chapter 3. Unlike the next generation bank, which would also require a shift of system boundaries in regulatory terms, the leading practice bank conveys ESG practices and business models that have be proven to function within current system boundaries. Finally, chapter 4 details the profile of the next generation bank and suggests a roadmap towards the next generation bank for banks, regulators, politicians and other stakeholders.

11 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking Current situation of the Swiss banks ESG is better integrated in lending than in mainstream asset management activities. The variations between different types of banks in terms of exposure level and ability to influence serves as the basis for the analysis presented in this chapter. First, the current state of ESG integration by Swiss banks in both banking and asset management activities will be addressed. Secondly, the ESG performance of the sector will be analysed by type of bank. ESG performance of Swiss banks by activity The results of the analysis of the banks ESG performance show a clear difference between banking and asset management activities, which can be related to the underlying performance drivers of these activities. In analysing the results, both the average scores and best in sector scores on the different assessment parameters as well as the gap between the two provide valuable insights. Figure 2: Banking activities Asset management activities Sustainability strategy 100% Sustainability strategy 100% 80% 80% Key environmental issues 60% 40% 20% 0% Integration into business activities Key environmental issues 60% 40% 20% 0% Integration into business activities Governance Products and services Governance Products and services Best score in sector score Sector Average average score score Source: KPMG Advisory NV.

12 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 11 Best performance across activities on the integration of sustainability in product development. Products & services Asset management Banking Source: 53% ESG integration in product development focussed on sustainable products rather than mainstreaming. Sustainability strategy Best in sector score Sector average Source: KPMG Advisory NV. 36% KPMG Advisory NV. 67% 75% Area of attention in banking is development of sustainability strategy, in asset management it is integration into business activities. Figure 2 presents both the average performance and best scores of the Swiss banks researched. Based on the best scores, it shows that so far the banks have been better able to integrate ESG-related factors across categories into their banking divisions than into their asset management divisions. In both banking and asset management, the banks display highest averages and best scores in the category products and services (a). A striking result is the significantly higher average score for products & services in asset management. In this area, the banks seem to be more advanced in offering specialised sustainable products than in banking. Regarding the integration of ESG into the products and services area, the banks mainly offer specialised sustainable products instead of systematically integrating ESG aspects into their mainstream product development processes. Consequently, the share of sustainable assets under management of the Swiss banks is still relatively small. Often, banks create sustainable versions of existing products and services instead of offering product innovations aimed at steering investment towards sustainable sectors and business models. Although in banking the highest scores in the areas other than products and services are fairly equal, the widest divergence is observed in the scores for sustainability strategy. This can be attributed to the differences in the types of bank and the level of exposure to environmental issues. In asset management, the participating banks show a more homogeneous performance i.e. smaller differences are observed between the average and best in sector scores. Despite the consistent scores on integration and governance, hardly any of the banks systematically identify, assess, control and monitor environmental or social risks and opportunities at inception and throughout the lifetime of all of their originated loans and/or investments. The banks do not seem to consider environmental challenges to be a strategic business issue (e.g. impacting credit risk) for mainstream investment risks and opportunities. In their asset management divisions, the banks score lowest on integration into investment processes. Although most of the banks have an ESG policy framework in place when it comes to the selection of individual securities, there is room for improvement in the integration of ESG factors into mainstream activities. ESG investing is limited in most of the banks to the development of niche portfolios of dedicated socially responsible investment (SRI) products and occasionally sustainable discretionary mandates. It seems that little attention is given to integrating ESG factors into the various steps of the mainstream investment process such as macroeconomic analysis, definition of the asset allocation or portfolio construction and implementation of all assets under management (AuM) under the control of the bank. Note: (a) This finding is however not attributable to the integration of ESG criteria in mainstream product development processes; instead it reflects the growing popularity of specialised sustainable offerings

13 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 12 Key environmental issues are not considered strategic in banking. Banks apply sectorspecific policies or general sustainability policies to deal with ESG risks and adhere to minimum standards. The Swiss global banks, regional and cantonal banks and private banks studied do not seem to consider specific key environmental themes as strategic business or investment opportunities for their banking activities. Banks aim to manage the downside risk of sector-specific ESG factors in the transactions they pursue and are less focussed on the strategic management of specific environmental issues. The banks do not in general have policies or guidelines for specific cross-sector environmental issues like climate change or water. Global banks have developed sectorspecific policies detailing minimum standards and guidelines applicable to their lending business, that generally comply with the minimum standards formulated by authorities in the respective fields, minimising any potential public fallout over noncompliance. Smaller banking institutions, with lower levels of exposure to specific sectors or issues and lower ability to influence, typically have only a general sustainability policy rather than sector-specific policies.

14 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 13 Banks with higher exposure to sustainability issues score better. Low exposure banks have a more marketdriven response particularly to sustainability opportunities. High exposure banks have a clear business case for managing sustainability risks and opportunities. ESG performance of Swiss banks by type of bank Figure 3 shows a significant difference in ESG performance between banks which are highly exposed to sustainability-related risks and which have a high ability to influence responses to environmental challenges and banks that are less exposed and have less influencing power. Banks with a high risk exposure and ability to influence have a business case for managing ESG factors due to higher risk levels and also in part due to their broader business opportunities. They are also motivated by stakeholders (e.g. NGOs or consumers) who expect them to mitigate any negative environmental externalities of their business. In line with their higher risk exposure to environmental issues and the greater impact they can make in solving the respective challenges, global banks today seem to be better prepared to deal with ESG issues in banking than regional & cantonal banks and private banks. For banks with a low risk exposure and low ability to influence, the business case is less clear and they are, in general, less vulnerable to stakeholder pressure. As such they are much more driven by conventional business pressures like client demand. This is demonstrated by the fact that banks with a low or medium level of exposure and ability to influence are relatively strong at creating special sustainable product and service offerings, yet these are often restricted to niche offerings rather than an overall product range driven by ESG considerations. In addition, the low and medium exposure banks appear to be less advanced in the areas of policy and strategy development, integration into business activities and management of specific environmental issues. Figure 3: Banking activities Asset management activities 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Sustainability strategy Integration into business activities Products and services Governance Key environmental issues 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Sustainability strategy Integration into business activities Products and services Governance Key environmental issues Average score Best score Average score of banks with high exposure and ability to influence environmental issues Average score of banks with medium exposure and ability to influence environmental issues Average score of banks with low exposure and ability to influence environmental issues Source: KPMG Advisory NV.

15 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 14 In asset management, low exposure private banks are competing with high exposure global banks in offering sustainable products and services. The ESG performance of asset management activities by the different types of banks shown in figure 3 follows almost the same pattern as in banking. In this area also, banks which are highly exposed to environmental risks and have a large potential influence on environmental issues show the highest ESG performance. The exception to the rule seems to be that private banks (low risk exposure) seem to compete more easily with global banks in this respect than they do in the area of banking activities, as their activities are more client- and opportunity-driven and they have an international rather than a regional reputation to uphold. Conclusions on findings for the current situation of the Swiss banking sector All of the banks interviewed have established a certain set of ESG policies and sustainable product offerings; Almost none of the banks systematically identifies, assesses, mitigates and monitors environmental or social risks at inception and throughout the lifetime of all its originated loans; Banks have generally not developed incentives to reallocate assets to sustainable alternatives; In the area of asset management, scores are much more even between the types of banks. Smaller banks seem to compete more easily and favourably with the global banks in product-driven asset management services by offering sustainable niche products; Banks are more advanced in offering sustainable products in asset management than in banking. This can be explained by the more productdriven nature of asset management compared to banking. However, the integration of environmental considerations in mainstream product offerings appears to be very limited; On key environmental issues, the global banks seem to take a risk perspective and not so much a business opportunity perspective. The banks surveyed have not attempted to report on their exposure to the key environmental issues or their involvement in sustainable alternatives, indicating that these are not considered key reporting requirements.

16 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking Today s leading practice bank Today s leading practice bank combines existing leading practices in banking, asset management and regarding key environmental issues. ESG is considered enhanced risk management in banking. Today s leading practice bank combines the leading sustainable practices which are currently applied by the banks surveyed into one hypothetical bank profile. In this chapter, the characteristics of such a leading practice bank are described, distinguishing between general features and examples of leading practices in the areas of banking, asset management and key environmental issues. The leading practice bank is not intended to describe the best possible application of ESG integration within current system boundaries, but merely shows today s leading practices observed at the Swiss banks analysed. Where no leading practice could be identified for a given assessment category, this is indicated accordingly. Although some basic aspects attributed to the leading practice bank are applicable to any bank (e.g. integration of ESG aspects into corporate strategy, governance), banks should adopt those features appropriate for their respective business model. The leading practices presented can serve as a model for banks that are less advanced on the sustainability agenda, however they are not sufficient to trigger the required transition towards a sustainable economic system. The characteristics of such a change-making bank are discussed under the heading next generation bank in chapter 4. Today s leading practices in banking In today s leading practice bank, sustainable banking is considered as a form of enhanced risk management. Consequently, the bank has strong risk management systems in place, focussing on environmental, social and governance risks, and is taking certain measures to influence the unsustainable behaviour of clients. However, measures focussed on capital allocation from less sustainable to more sustainable sectors and clients and other types of transformative practices of significant scale are currently lacking. The leading practice bank offers sustainable banking products and services to its clients, however these are mostly sustainable versions of existing products and services rather than innovations within the mainstream product portfolio.

17 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 16 International standards and principles create the basis for sustainable lending and financing. Sustainability strategy In today s leading practice bank, ESG is integrated into corporate strategy, reflecting the corporate ambition to shift investments and financing towards more sustainable industries and business practices. As part of its strategy, the leading practice bank applies the Equator Principles or equivalent standards to all types of lending and financing, going beyond merely applying them to project finance. Today s leading practice bank has a strong formal environmental and social risk management framework in place to manage ESG risks on a companywide basis. This framework is implemented throughout the organisation and is externally certified according to an internationally agreed standard (e.g. ISO 14001). In this context, it is regularly verified by an independent party. Part of the framework are sector policies which contain the bank s aspirations towards more sustainability in a number of sectors and state minimum requirements for doing business in these sectors. In addition, the leading practice bank has a policy describing controversial practices (e.g. mountain top removal, heavy infrastructure, plantations) which are excluded from its business or subject to stringent pre-established guidelines. This policy is applied to all business divisions in transactional and client due diligence processes. International standards and principles create the basis for sustainable lending and financing. At one of the banks analysed in the study, sustainability constitutes one of six group priorities, thus forming an integral part of corporate strategy. Two of the sample banks developed policies and guidelines for high-risk sectors such as mining, oil and gas, palm oil, forestry or hydropower. The sector policies are applied to all products, services and transactions which carry potential ESG risks. Where no sector-specific policies and guidelines are available, one of the banks uses the IFC performance standards.

18 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 17 The leading practice bank is not very advanced when it comes to quantitative target setting for the management of environmental and social risks in banking activities. So far, only qualitative targets have been set. Similarly, there are no examples of the development of a formal climate change or water policy to manage these risks in banking. In general, the leading practice bank systematically assesses material environmental, social and governance risks within its lending portfolio instead of restricting ESG risk management to transaction and individual client level. One bank, as part of its environmental and social risk management system, reviews the environmental and social risks, reputational risks and operational risks of all products and services each year. For products and services identified as having significant environmental and social risk potential, business divisions are required to apply adequate procedures and tools for the identification, assessment, escalation and monitoring of such risks and to integrate these procedures and tools into standard risk, operations and compliance processes.

19 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 18 Different instruments are used for the assessment, monitoring and management of ESG risks. Integration into business activities On the operational side, today s leading practice bank implements formal processes and procedures to systematically assess and manage the ESG risks of its lending and financing transactions and portfolio. At transaction level, the ESG risk management framework, including the sector policies mentioned above, provides the basis for identifying and mitigating risks. Once the transactional risks have been assessed, the outcomes of these risk assessments are used to classify ESG risks on a scale according to their relevance. However, only governance criteria are generally taken into account in the final credit rating of a client and are integrated into the credit pricing model. The leading practice bank also addresses ESG risks in a dialogue with its commercial and retail clients. Two of the banks included in the study have a formal process in place to engage with potential and existing clients on sustainability issues. They set targets, formulate action plans with clients and monitor compliance towards these agreements. From a portfolio perspective, the leading practice bank periodically reviews the ESG risks, reputational risks and operational risks of all its products and services in the context of its environmental and social risk management process. One of the sample banks carries out a regular ESG risk assessment such as this. For products and services identified as having significant potential environmental and social risks, the bank s business divisions are required to apply adequate procedures and tools for the identification, assessment, escalation and monitoring of ESG risks and integrate these procedures and tools into standard risk, operations and compliance processes. Where risk mitigation with regard to its lending portfolio is concerned, the leading practice bank takes certain measures to reduce the environmental and social footprint of its entire lending portfolio. As a first step, the bank assesses and monitors the ESG risks of new and existing banking products and services. Subsequently, it designs and implements to some extent measures within its investment banking division to reallocate business activities from unsustainable to more sustainable sectors.

20 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 19 In order to be able to measure changes in environmental performance, ESG data is integrated into the mainstream information management systems of the leading practice bank. One of the banks included in the study has created an initiative which allocates budgets to pursue sustainable investment opportunities. This initiative provides capital-raising and strategic advisory services to renewable energy and cleantech companies around the world. Products and services Two types of activities can be distinguished when analysing the ESG performance of the products and services of a bank: the development of specialised sustainable products and services and the systematic integration of ESG-related factors into the mainstream product development process. Today s leading practice bank mainly focuses on the former, meaning that it offers ESG-related banking products for both its retail banking and investment banking divisions and has just started to capitalise on business opportunities in the field of sustainability. Several of the banks analysed developed sustainable mortgages or sustainable products in areas such as climate protection, water, smart mobility and renewable energy. With regard to the integration of ESGrelated factors into their mainstream product and services offerings, no consistent leading practices could be identified. ESG-related factors are only taken into consideration in mainstream product development processes for certain lending or investment products or on an ad-hoc basis. This results in the development of specialised sustainable products and services as described above, however less so in ESG integration in the mainstream products and services of the banks. In any case, sustainable innovation in product development requires that managers from different divisions work together to share knowledge and ideas on how to drive change towards more sustainable performance in products and services. One of the banks in the study has set up a green forum where managers from areas like renewable energy, private equity, asset management and research exchange knowledge and ideas to promote more sustainable products and services. Governance The corporate strategy of today s leading practice bank is underpinned by a strong governance structure, in terms of size of the ESG teams and the organisational structure, to manage the ESG performance of its banking division. This implies that executive and senior management have a formal role and responsibility with regard to the ESG performance of the bank. On the other hand, ESG-related factors are not yet integrated into the formal targets or remuneration schemes of individual board members or other senior executives. Such hard controls on ESG performance are still missing, meaning that managers ESG competencies and performance are not yet consistently and regularly assessed and monitored. Thus, ESG is not yet part of the mainstream performance management system of today s leading practice bank.

21 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 20 ESG factors are integrated in investment processes regarding both SRI and mainstream funds. Today s leading practices in asset management Sustainability strategy In the field of asset management, today s leading practice bank integrates ESG factors into its investment processes by systematically including environmental, social and governance risk factors in each process step of the mainstream asset management operation. As an example, three of the sample banks have also started to integrate ESG factors into some parts of their mainstream investment processes, rather than limiting ESG to the development of dedicated SRI-niche products and sustainable discretionary mandates. The leading practice bank has developed exclusion policies i.e. on anti-personnel landmines and cluster munitions, which apply, on a global scale, to all the investment products and services of the bank. Membership of the United Nationsbacked Principles for Responsible Investment initiative (PRI)] does not appear to be a central driver behind the ESG investment strategy of today s leading practice bank. The main reason for this is that the bank s ESG investment approach is strongly clientdriven, which means that the scope for ESG integration also depends greatly on client needs and expectations. In the area of asset management, as in the area of banking activities, today s leading practice bank has only formulated qualitative, and not quantitative targets, to manage ESG risks.

22 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 21 Integration into asset management activities Today s leading practice bank formally integrates ESG factors into the mainstream investment management processes of a limited part of its portfolio. In addition, it embeds ESGfactors into the mainstream management selection processes of internal or external asset managers. Conversely, ESG-factors are not taken into account during strategic asset allocation processes. ESG investing is applied to different asset classes, although the scope of application of ESG investing practices at today s leading practice bank is limited compared to the overall size of its assets under management. In general, ESG investing is considered as a separate investment strategy which is detached from the mainstream investment processes and practices. Products and services With respect to the ESG performance of products and services within the asset management division, two conclusions can be drawn regarding today s leading practice bank. On the one hand, sustainable asset management products and services are part of the standard offerings of the leading practice bank to both private and institutional clients. The bank capitalises on sustainable business opportunities more than in banking. As such it offers a selection of traditional SRI funds (a combination of exclusion and best-in-class selections), thematic funds and sustainable discretionary mandates. The thematic funds offered are mainly focussed on cleantech, demographic change, water scarcity, future resources and renewable energy. On the other hand, similarly to the banking division, the leading practice bank has just started to integrate ESGrelated factors into its mainstream product and service offerings of its asset management division. The development of specialised SRI products and services which do not improve the ESG-performance of mainstream investment products still prevails. One of the sample banks develops tailor-made sustainable funds and products based on the client s view, needs and expectations, rather than offering a standard set of sustainable products and services. As a result of this business model, the bank needs to integrate ESGrelated factors throughout its entire product value chains including mainstream product development processes. At the moment the share of this advisory-based SRI portfolio in the overall investment portfolio is still limited however, to between 1 and 5%. In the process of fund selection, research initiatives on future-oriented themes are used to track new investment opportunities and a best in service approach is taken to identify companies that are involved in technologies meeting future global demands sustainably (e.g. energy supply). In other words, the sustainability performances of technologies which fulfil the same function (e.g. power generation) are compared and only the most sustainable solutions are invested in. Another bank has developed an ESG classification scheme for each of its SRI and mainstream funds. For each fund the bank examines the level of ESG integration, resulting in a sustainability indicator. This indicator is communicated to the clients, enabling them to evaluate how sustainable their investment portfolios or funds are. Governance In its asset management division, today s leading practice bank exhibits less hard controls and stringent governance than in banking. A possible explanation is the fact that ESG management within banking activities is mainly driven by risk, which fosters the creation of strong organisational structures and controls. In contrast, ESG investment in asset management is mainly driven by opportunity, therefore weaker control mechanisms and structures are considered sufficient. The leading practice bank combines a separate ESG investment function with the integration of ESG into the job responsibilities of some mainstream investment analysts and portfolio

23 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 22 Key environmental issues are addressed directly and through sector policies. managers. In addition to assigning a formal responsibility for ESG investment to one or more senior managers within the asset management division, this setting targets for ESG investment for managers and employees in pertinent departments and monitoring progress towards these targets. ESG factors are however not yet taken into account in the remuneration schemes of the senior managers. Today s leading practices: key environmental issues The key environmental issues identified by WWF in relation to banking and asset management are decarbonisation, water, soft commodities, mining and hydropower. With the exception of water, certain leading practices could be identified for each issue to build a starting point from where these environmental challenges could be addressed. Today s leading practice bank is taking a first step towards mitigating its carbon exposure in asset management by determining the CO2 footprint of the portfolio of individual clients. Such transparency on the environmental impacts of investments is a precondition for clients to be able to reduce or neutralise the environmental externalities of their investments. In addition, the leading practice bank engages employees and clients on climate change issues in private and public forums and provides additional support to clients in the design of solution-oriented products and services. One of the banks from the survey developed a green portfolio service. This service enables its clients to reduce or fully offset the CO2 emissions of their equity investments. The leading practice bank engages with clients in the palm oil and forestry sectors, aiming to lead them towards more sustainable business practices. However it does not yet systematically address the environmental and social risks for all relevant commodities through policies or minimum key performance indicators. The leading practice bank has implemented a mining policy that applies to all business activities and products and services of the bank. In the case of hydropower, a hydropower guideline has been implemented that precludes investment in hydropower projects at certain environmentally sensitive sites.

24 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking The next generation bank This chapter describes the characteristics of the next generation bank a bank which addresses its impact on the environment and society, strategically acknowledges environmental challenges and assumes its role and responsibility for driving the change towards a more sustainable economy. The next generation bank has been conceived based on the findings of the analysis carried out in the previous chapters and the insights from the expert interviews. As opposed to today s leading practice bank, which by design is feasible within current system boundaries, the next generation bank requires a fundamental shift in the way banks assume their role towards driving environmental change in the economy. The roadmap presented in this chapter describes one possible way of bridging the gap between these two banking models and economic systems. It includes an outline of the barriers which exist and the role different actors have to play in overcoming them and driving change. Throughout the chapter quotes from the expert interviews are used to illustrate the background and concept of the next generation bank. While the questions asked triggered a variety of views and opinions, all the experts agreed on the point that the first and foremost duty of this future bank is to serve the real economy. For the next generation bank to become operative though, a fundamental shift in ways of doing business is needed.

25 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 24 A fundamental shift is required. The most important transformation that will take place in the coming decades and that already has started, is a fundamental change and restructuring of the way in which we produce and consume goods and services. Our economy will be transformed from a linear process to a circular process in which resources are used over and over again (like in nature itself). With our current way of producing and consuming we have reached the limits of our planet, indicated by e.g. the growing environmental impact and resource scarcity (e.g. water, minerals). Taking into consideration the growing wealth and population in the world in the coming decades as well, it is clear that our economic system will and needs to change considerably. (Herman Wijffels, Professor in sustainability and societal change at the University of Utrecht) The findings from this report indicate that today s leading practice bank is taking important first steps, but that they are not sufficient to trigger the required transition towards a sustainable economic system. Most of the experts interviewed point out that a fundamental shift beyond incremental improvements by individual banks is required. Compared to other financial systems, the Swiss banking system seems to be doing relatively well and is in a relatively good situation to drive change towards more sustainability. But this relative consideration should not delude us into thinking that the whole system is degenerated. (Thomas Dyllick, Professor for sustainability management at the University of St. Gallen) Although there are some pioneers of sustainable investment in the Swiss market, with the exception of a few firms, examples of current leading practice in the financial market are relatively poor compared to the environmental performance and the level of strategic integration of sustainability as business principles in other sectors of the real economy. (Reto Ringger, Founder and CEO of Globalance bank) According to the experts, the current practices of creating green products or moving towards a more systematic approach of integrating environmental and social risks are only a good start. Within the product area, banks have started looking at environmental and social issues related to project financing and lending. However they still limit their assessment to reputational risks linked to their financial exposure. This does not yet reflect assuming responsibility for the impact of what they do or their contribution to society. (Dyllick)

26 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 25 The role of a bank is to serve the real economy. Compared to the producing economy, banks are lagging behind in a strategic approach towards sustainability. The experts interviewed agreed that stability in the financial market is a prerequisite for a well-functioning and more sustainable economy, but also that the financial market does not respond to those conditions: The financial sphere has reached a size far beyond what is required to support the real economy and as such is a source of volatility in the real economy. The financial sphere is able to attract a huge amount of capital, which could flow into the real economy to create real solutions to the current challenges e.g. environmental challenges. As the capital currently stays in the financial sphere and is moving around in exotic products, there is currently a huge misallocation of capital. (Marc Chesney, Professor of finance and head of research priority program finance and financial markets at the University of Zürich) The challenge for banks will be to find adequate responses to an imminent economic transition, within fair constraints: In contrast to the banking industry, there are examples in the real economy where companies understand the strategic relevance of environmental issues.. One trigger has been reputation and increasing pressure by the public and NGOs. But also a growing understanding that long-term economic success is not possible, if the environmental conditions we are operating in are destroyed. (Albert Baehny, CEO, Executive President of the Board of Directors at Geberit) Systemic risk and instability of the financial system is probably the most severe risk to sustainable development overall. (Dvllick) Instability is negative for the real economy and favours hedge funds and speculators. As long as the system is not stabilised, it will generate short term behaviour and make sustainable investments very difficult. (Chesney) Sustainability in the banking sector means the stability, integrity and quality of the banking services. There is a strong link to the debate around too-big-to-fail, since it is important to ensure that future generations and tax payers will not be accountable for potential deficits today. (Ines Barnetta, Economist, state secretariat for international financial matters SIF, Switzerland) We have to understand again that banks are not shaping the world. Their role is to serve the real economy by distributing the money at the correct price. To support the transition towards a more sustainable economy, banks should favour and support sustainable economic solutions, while scarifying short term unsustainable solutions within their business offerings. (Baehny)

27 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 26 The financial crisis can also be a change for sustainability: banks have to re-think their business-model. From the banks perspective, the current period is difficult, since banks are strongly focussed on de-risking and deleveraging their balance sheets. Consequently, the banks are focussed on their financial performance and less on changing their business models. The financial crisis is both a hurdle and a chance for more sustainability. As banks will be forced to reconsider their business models, there might be a chance to drive the change towards more long-term thinking, including environmental aspects. At the same time, banks will be occupied with coping within a difficult economic environment and a flood of regulations over the coming years, where sustainability might not be at the top of the agenda. (René Buholzer, Head of public policy, Credit Suisse)

28 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 27 Defining the next generation bank We need to have a clear idea how the future banking sector should look, a clear description of an end point. This end point could be translated into a new implicit social contract between society and the banking sector that describes the societal expectations towards banking. (Wijffels) From the interviews conducted, the following ten principles can be identified as a starting point to define the next generation bank: 1.The next generation bank serves the real economy with products and services needed to meet the demand of companies and households; 2.In serving the real economy, the next generation bank assumes the responsibility for managing the broader short- and long-term impacts of its decisions and activities, taking systemic, environmental, social and governance factors into consideration; Banks should be subservient to the transformation of our economy from a linear to a circular economic system, not only to fulfil their social role but also from a risk management perspective. The levels of uncertainty and discontinuity will continue to increase within our economy. We cannot take it for granted that we will have the same natural resources at our disposal in the future as we do today. Good risk management of a bank means taking these types of risks into consideration. (Wijffels) 3.The next generation bank deploys sophisticated models to assess the short- and long-term social and ecological impact of its activities, without relying on such models alone. Such impacts influence the pricing and capital requirements of its exposures; There seem to be clear signals that clients want more sustainability, but there is a lack of competence related to sustainability in the financial market. Just compare the number of excel spreadsheets and the efforts developed around currency trading with the efforts to develop models on how to integrate environmental and social issues into investment decisions. (Ringger) The most appropriate way to reallocate capital from unsustainable to more sustainable sectors and business practices is probably to work on projects to integrate environmental and social criteria into the risk models. Internalising external costs despite the challenges of monetising may also be an appropriate way going forward. (Buholzer) Scarcity of resources could be priced via risk management of banks, leading to premiums or discounts in the cost of capital for companies with less or more sustainable business models. (Lex Hoogduin, Professor of monetary economics and financial institutions at the University of Amsterdam) 4.Performance indicators, earnings, incentive and fee structures promote long-term over short-term considerations. They avoid profit generation from taking risks or selling products that are not serving the real economy; Before the next generation bank can become a reality, there is a demand for a systemic change (system transformation) to make the financial market as a whole more sustainable. The next generation bank requires a completely different business model, where fee structures, earnings, performance indicators and incentives are linked to the long-term positive impact for the real economy, for society and the environment. (Dyllick) 5.The next generation bank shows leadership and courage in explaining long-term strategic decisions to shareholders; The argument that a single bank cannot take a long-term strategic approach towards sustainability in their business decisions due to quarterly pressure from shareholders is a simplistic excuse. Many examples from the real economy show that it is a question of explaining a consistent strategy to the shareholders. Of course there will be situations where it hurts and long-term environmental investments will be in conflict with short-term earnings. The CEO has to able to explain this to the shareholders and they will take their decision. In the real economy you have CEO s willing to take the risk of a long-term strategy and to explain this to the shareholders. There should be CEO s in the banking industry that are willing to take this risk.

29 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 28 6.The next generation bank develops the competence, skills and expertise of its employees regarding sustainability and fulfils its primary function of serving the real economy. It also works closely with external parties to develop the required expertise; To be able to assess the environmental and social impacts of business decisions in investment and financing, banks will have to build up new networks and use expertise and know-how outside the banks as well. Until now, banks tended to develop most of the skills and expertise inhouse (in contrast with other sectors, which outsource most of these activities). Given the complexity of environmental issues, banks will have to revise their approach and work much more closely with other actors outside the banking industry. (Ringger) 7.The next generation bank has an ownership structure that is commensurate to its function in the financial system and promotes sustainable behaviour in banking by taking a stakeholder rather than shareholder perspective in evaluating its activities; The ownership structure has an influence on the risk-taking. Therefore change towards more sustainable behaviour in banking is more likely to occur today in smaller banks with adequate ownership structures. (Chesney) 8.The next generation bank has a strong foundation of values to ensure sustainable decisions and coherent behaviour, including under adverse circumstances; The next generation bank requires a strong foundation of values. Values are necessary to ensure sustainable decisions and coherent behaviour including in economic recessions and stormy times. (Ringger) The culture within the banking sector is compliance-driven and not valuesdriven. Without clear values and ethics it is difficult to fulfil a social role as an organisation. The culture of banks should be transformed from a compliance to a more values-driven culture. This will also have a positive impact on the mindset of the people working in the banking sector. (Wijffels) 9.The next generation bank promotes transparency and reports on its activities not only with a focus on its financial performance and risk management, but also with regard to the non-financial contribution and the negative externalities caused by the activities it has financed; The aim should to be to remove the barriers that exist between sustainability and the economy, in other words between social return and financial return. We should look for measures that remove the barriers and align both forms of returns (e.g. movement to integrated reporting, public private sector partnerships). (Hoogduin) 10.The next generation bank provides the appropriate offerings for the needs of its clients. It ensures transparency towards its clients on the financial risks attached to its products and services but also on realistic return expectations and the broader economic, social and ecological impact of the products and services; One of the most relevant aspects and preconditions for sustainable banking is transparency: where does the money go and even more importantly, how does the money work? Banks and clients have to understand that money is not neutral. Your money can feed, cure, or do harm to the environment, depending on your investment choice. (Ringger)

30 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 29 Barriers, roles and responsibilities on the way towards the next generation bank Although some banks are closer to the profile of the next generation bank than others, for many banks there will be a long way to go to adopt the principles above. While there are many actions that banks can take themselves in evolving towards the next generation bank, some restrictions have to been taken into account. Banks are limited by many restrictions, such as clients return expectations and increasing compliance and regulation and they act with limited degrees of freedom to introduce change towards more sustainability and long-term decisions. (Ringger) When discussing how to make the banking sector more sustainable, it is important to consider the financial sector as whole, including all its stakeholders (e.g. governments, consumers). Increasing sustainable finance is a multi-actor problem. (Hoogduin) It would be unlikely to find one global solution to the fundamental problem of a degenerated financial system. It is more likely that it will require activities at different levels involving many different actors. (Dyllick) Based on the experts views, this paragraph will explore some of the barriers as well as the specific roles and responsibilities that banks, regulators, academia and other stakeholders have to assume in overcoming them. Barriers With the financial market either in crisis or recovering from one and with banks dealing with new regulations in the aftermath of government bail-outs and looking to de-risk and deleverage their balance sheets, banks face a number of challenges when seeking to improve their environmental and change-making performance: The key responsibility of banks in society is to be profitable, to operate in compliance with laws and regulations and to know and meet their stakeholders needs. Sustainability in the banking sector could be defined as a long-term benefit for key stakeholders. Such a long-term approach must correlate with economic profitability. And this is apparently one of the challenges. (Buholzer) The experts from banking refer to the strong peer pressure. One important barrier to change is the highly competitive landscape for banks. Prior to the financial crisis, the behaviour of banks might have been triggered by a certain euphoria. Now, the financial sector is in a state of anxiety and looking for security. Both are probably not adequate for a courageous and strategic approach towards more sustainability. (Buholzer) Current financing and funding practices are based on cash flows and net present values of these cash flows. In other words, everything is translated into the here and now. The shorter the payback period of loans, the better it is. However, sustainability, by definition, needs a longer time horizon and thus different financing and funding practices are needed. (Wijffels) In summary, one expert states: Within the current system, big banks changes towards sustainable banking are not really possible without serious changes in the whole financial system. (Chesney)

31 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 30 The role of the banks There are different views among the experts about the extent to which banks themselves are able to drive the change towards the next generation bank. It is not enough and seems to be a simplistic excuse for banks to wait for regulators to act or for the system to change. Although a systemic change is needed, there is a lot that banks could already do today. They should start think how their own investments and financing decisions are affecting the economy, society and the environment and come up with their own suggestions for indicators. Also, banks should speak up to push system-wide change. In addition, they should be more transparent (report more) on the sustainability of their lending, financing and investment activities. (Dyllick) The next generation bank requires a shift in attitudes and mindsets not only within banks but also on the side of their shareholders. Only if shareholders start taking decisions in favour of more long-term oriented, sustainable business models is there room for bank CEO s to structure their approaches accordingly. Currently, it is not clear to what degree courageous decisions from individual banks would be recognised as such or rewarded by shareholders. In any case, the pathway towards the next generation bank seems to require leadership and the willingness and courage of CEO s to take a clear stance in explaining their long-term strategy and strategic approach towards environmental issues to their shareholders. One of the biggest challenges for sustainability in banking is short-term thinking. This is true for decisions taken within the banks, for incentive structures, quarterly reporting for investors and for shareholders. Not only banks, even pension funds which should invest the money for our retirement according to long-term goals, act within the short-term, quarterly paradigm today. The ability of a single bank to overcome this challenge is very limited, since it would be nearly impossible for a CEO of a publicly-listed bank to ignore quarterly results and take long-term decisions instead. (Ringger) Whatever sustainability strategy a bank pursues, increasing transparency seems a good starting point. This will enable the bank to create the level of information required for discussing the impact of and consequently the appetite for environmental and social risks internally and with its clients. Although banks cannot solve the remaining issues alone, there are many ways in which banks can be much more transparent about the consequences and impact of their activities than they are today. There are very few examples where banks develop models to show the sustainability footprint of a portfolio to clients. The lack of transparency in the banking sector today prevents clients from taking informed decisions with respect to sustainability issues. (Ringger)

32 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 31 If environmental aspects where part of the regulatory framework, they would be much higher in priority for the banks. The role of regulators. Among the interviewed experts, the assessment of the role of regulators and regulation in driving the change towards more sustainability differs. Since banking activities and decisions are substantially driven by compliance, it is necessary to address some environmental and social requirements through the regulator. This would immediately change the agenda and priorities related to environmental issues in banking. (Ringger) While more regulation is not the solution in fact, the focus should be on simpler and more efficient regulation if regulators demanded environmental stress tests and scenarios from the banks, we would have a completely different discussion around environmental topics. (Buholzer) It could be a potential way to kick-start the development towards a better integration of environmental aspects into the decision-making of banks, if the regulator required more transparency and accountability on environmental impacts. (Barnetta) Integrating sustainability-related factors into Basel III might not be a good measure. Let the market do the work. Governments should utilise the role of the market as much as possible on this. However, since both markets and governments are imperfect systems, cooperation is a good solution. (Hoogduin) Some experts comment on the complexity of financial products: The complexity of financial products and the market as such are a threat to a stable financial market that would enable sustainable decisions. Today there are many cases where not even bankers themselves understand the way new financial products work. This is very dangerous and can be compared to an engineer who does not understand the plans for the bridge he is constructing. (Ringger). To reduce the systemic risk inherent in financial innovation, there should be an homologation process for every new financial product. When a bank wants to launch a financial product, it should show that it serves the real economy. This is a standard requirement in many other industries: when a company plans the go-tomarket for a new car or a pharmaceutical product, nothing can be launched without defined upfront quality control. It does not make sense that financial products, which have such a huge and potentially negative impact on the economy and the environment are regulated less or not at all. (Chesney) A contrary view from another expert links the effectiveness of regulation to the level on which it is applied: Rather than micro-managing and forbidding certain financial products, regulatory intervention seems to be much more appropriate on a macrolevel. (Buholzer)

33 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 32 Some experts have also commented on the current flux of regulations dealing with financial risk, asking whether stricter regulation reducing the risk at individual banks is actually helping the system to reach the conditions required for more sustainable allocation of capital: The current developments regarding banking regulations will lead to even more homogeneous business models in the banking sector. The future will show whether this development will prove counterproductive in the end by enhancing systemic risks rather than reducing them. (Buholzer) The next generation supervisor will have a stronger focus on macroprudential supervision and leave more room for individual institutions and potentially for a more differentiated sector in terms of idiosyncratic risks. This requires vision and courage. The role of academia (Hoogduin) The experts interviewed assert that in both practical banking and academia environmental and social externalities are not sufficiently integrated into financial models. In academia there also seems to be a need for new incentive structures: transition to more sustainable means of meeting long-term demands, the agency theory also requires looking at the clients of banks who themselves are not necessarily balancing sustainability demands with profit related-interests: Consumers and citizens should assume their responsibility as well. These stakeholder groups should also take more responsibility for social and environmental developments in our society and balance their call for sustainability with their own risk preference. This will lead to more demand for sustainable products and services. NGO s could support multiple stakeholders in adjusting their perception of dealing with sustainability: (Hoogduin) NGOs have a role in developing scenarios, showing solutions, mirroring to the banks their sustainability performance through ratings or benchmarking and by supporting pioneers. (Ringger) Research related to the systemic, environmental and social impacts of the financial sector s activities is not rewarded and rarely published by mainstream finance journals. There are no real incentives to analyse systemic, environmental and social risks. Other stakeholders (Chesney) Although it is fair to look at banks and see how they support an economic

34 Banks Regulators Politics Customers NGO Academia Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 33 Roadmap towards the next generation bank In dealing with what seems to be a multi-actor problem, what steps could be taken by whom to bring the next generation bank into practice? The table below lists potential steps to address the five most important challenges extracted from the initial study and the interviews with the experts. The roadmap should not be seen as definitive list of actions, but rather as starting point for further discussion. While the transition to a next generation bank can only be carried out as a joint effort and with cooperation between different actors, banks have a responsibility to trigger this transition by actively mainstreaming ESG into their core business. No. Challenges Step 1 Instability of the financial market 1.1 Review capital requirements against the need for a longer term view and stakeholder perspective (increase absolute levels and provide capital incentives for long-term investments) x x x 1.2 Reduce high frequency trading and stimulate active ownership (longer holding periods) x x 1.3 Allow for diversified idiosyncratic risk profiles among banks under stronger macro-prudential (countercyclical) supervision 1.4 Reduce the salary gap between banking employees and regulators (higher financial incentives for regulators and lower bonuses for traders) x x x x x x 1.5 Introduce external product approval requirement for complex financial products, showing the economic, environmental and social benefit of the offering 2 Lack of transparency and complexity of products x x 2.1 Develop practical tools for measuring environmental, social and systemic impacts 2.2 Assess, measure, monitor risks in the portfolio related to environmental and social issues and the economic impact of the financing activities throughout the lifetime of all loans and investments, to be captured by an economic and social management system x x x x x x 2.3 Develop a risk appetite statement on ESG risks on portfolio level in SMART performance KPI, supported by pricing and capital allocation incentives x x (continued overleaf)

35 Banks Regulators Politics Customers NGO Academia Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 34 No. Challenges Step 2.4 Include environmental and social impacts in stress-testing scenarios x x 2.5 Disclose the risk approach towards and risk profile of ESG to the public in the annual report to promote market discipline and informed decisionmaking by stakeholders, including customers 2.6 Engage in sector initiatives to create a level playing field (e.g. apply Equator Principles to all transactions, OECD guidelines for multinational enterprises) x x x x x 2.7 Develop cooperation models with external parties to develop the required expertise on sustainability with pre-competitive funding arrangements x x x 3 Lack of entrepreneurial and responsible culture in banking 3.1 Develop fee and incentive structures to promote long-term over short-term risk considerations 3.2 Set up facilities to train bank employees with regard to ESG and sustainable banking behaviour with the target of providing all employees with a training commensurate with their function in the bank within three years x x x 3.3 Adopt sustainability as part of the academic curriculum of the next generation of executives x x 3.4 Reduce the salary gap between the real economy and the banking industry x 4 Lack of transparency and reporting on environmental and social aspects 4.1 Introduce integrated reporting x 4.2 Develop a consistent communication strategy to explain the long-term approach to clients and shareholders 4.3 Educate customers to enable them to balance calls for sustainability with their own risk preference and return on investment expectations 4.4 Develop a product and service communication protocol which captures the ESG factors of products and services as well as financial risk x x x x x x x x x 4.5 Agree to annual reporting on quantitative portfolio KPIs on ESG (comparable to PRI reporting or UN Global Compact communication on progress) x x Source: KPMG Advisory NV.

36 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 35 Final comments on the Next Generation Bank Developing a more conscious approach to serving the real sector in a changing economic environment has its challenges, but there is no need for any actor in the system to wait for others to take the lead. This chapter has listed ten principles detailing the profile of the next generation bank and a roadmap addressing the five most important challenges on the road towards the next generation bank. It will require leadership and courage to walk that road. Whether the latter are present in sufficient quantity is viewed with both optimism and pessimism by the experts: It should be possible to have a next generation bank within approximately 10 years. The current financial crisis will act as catalyst in this process. The crisis increases the external pressure of banks to change, including the selfcleaning capacity within the banks itself. Banks have changed with the influx of employees focussed on personal gain in the last ten to fifteen years, it could change similarly with a stronger influx of newly wired employees and pressure of more traditional, relationship-oriented bankers which is likely to be the majority of current bank employees in the future. (Wijffels) Despite the financial crisis there is no pressure on the banks to change. Central banks reacted to the financial crisis by guaranteeing access to cheap money to stabilise the system. We do not see any change in behaviour at all. For the next five to ten years the banks will be busy with things other than having a more strategic approach towards sustainability. (Baehny)

37 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 36

38 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 37 Appendix A: Assessment framework Performance on WWF topics Benchmarking model General sustainability performance Level of risk exposure to WWF topics: climate change, water, mining, dams, soft commodities Generic Sustainability drivers Transparency and reporting Environmental & social risk policies formulated Lending, financing and investment Environmental and social policies Public statements, principles and collaborations Scope of each WWF topicrelated environmental & social risk policy Lending, financing and investment portfolio Sustainability strategy Targets/objectives ESG investment principles and tools Public statements, principles & collaborations Asset management Scope of application of ESG investment tools Environmental and social risk/opportunity analysis Public statements, principles and collaborations Targets/objectives Targets/objectives Climate change Water Lending, financing and investment processes Risk management Investment opportunities Palm oil Forestry Other soft commodities Lending, financing and investment portfolio Integration into business activities Asset management Strategic asset allocation Portfolio construction Asset manager selection Hydropower Dialogue with investee companies Mining Green products related to WWF topics Green products related to WWF topics Lending, financing and investment Asset management Products and services Lending, financing and Investment Asset management Mainstream product development Green products Mainstream product development Green products Team Lending, financing and investment Organisational structure Governance Controls Team Asset management Organisational structure Source: KPMG Advisory NV. Controls

39 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 38 Appendix B: List of participating banks Name Credit Suisse UBS Zürcher Kantonalbank Basler Kantonalbank/Bank Coop Raiffeisen Group Bank Vontobel Lombard Odier & Cie Julius Bär Category Global bank Global bank Regional & cantonal bank Regional & cantonal bank Regional & cantonal bank Private bank Private bank Private bank

40 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 39 Appendix C: List of interviewees Albert Baehny Ines Barnetta René Buholzer Marc Chesney Thomas Dyllick Lex Hoogduin Reto Ringger Herman Wijffels CEO, Executive president of the board of directors at Geberit, Switzerland. Economist at the Swiss state secretariat for international financial matters (SIF), which is responsible for the coordination and strategic management of international financial, monetary and tax matters. Head of public policy, Credit Suisse. Vice director of department of banking and finance, professor of finance and head of research priority program finance and financial markets at the University of Zürich, Switzerland. Professor for sustainability management, managing director of the institute for economy and the environment, university delegate for responsibility and sustainability of the University of St. Gallen, Switzerland. Professor of monetary economics and financial institutions at the University of Amsterdam, former member of the board of directors of the Dutch central bank, chief economist at Robeco group and president of research institute IRIS. Founder and CEO of Globalance bank, former founder and CEO of SAM Group, president of the board of directors of WWF Switzerland and member of the Club of Rome executive committee. Professor in sustainability and societal change at the University of Utrecht, former chairman of the board of Rabobank Nederland, chairman of the Sociaal Economische Raad (SER) and director at the World Bank.

41 Environmental performance of Swiss banks Shifting Gears towards Next Generation Banking 40 Contact information Thomas Vellacott CEO, WWF Schweiz Hohlstrasse 110 Postfach 8010 Zürich Switzerland Katharina Serafimova Head of financial sector engagement, WWF Schweiz Hohlstrasse 110 Postfach 8010 Zürich Switzerland Barend van Bergen Partner, KPMG Advisory NV Laan van Langerhuize DC AMSTELVEEN The Netherlands [email protected] Erik van Dijk Senior manager, KPMG Advisory NV Laan van Langerhuize DC AMSTELVEEN The Netherlands [email protected]

42 2012 KPMG Advisory N.V., registered with the trade register in the Netherlands under number , a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. Printed in the Netherlands. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. The views and opinions expressed herein are those of the interviewees and do not necessarily represent the views and opinions of KPMG Advisory NV or WWF.