The Role of Sustainable Risk Mitigation in the Kenyan Financial Sector
Some people may be quick to say that the 2007/8 sub-prime mortgage induced financial crisis has been mentioned ad nauseam but with the upcoming 10th anniversary in 2017, it still serves a fresh reminder of the dangers of shallow implementation of corporate sustainability in the financial sector.
Let us all be honest for a minute.
Humans are falliable and they have a way of making history repeat itself.
As we await to handle the next business scandal, we still have to grapple with global warming, climate change, resource depletion and associated conflicts, food insecurity, [fill in the blank with the pertinent issue affecting your region] etc. The business community and in particular the financial services sector can address these environmental and social challenges with its wealth of financial and human capital through sustainable finance.
So how exactly does sustainability in the financial industry look like?
According to the Kenya Bankers Association, financial institutions can ensure long-term business success by recognising their environmental and social responsibilites while simultaneously meeting their economic responsibilites and financial objectives. This approach should enhance innovation, competitiveness and quality of the credit portfolio¹.
This translates to:
- having ambitious goals at the national and supranational levels, such as the sustainable development goals (SDGs) or Basel (banking) regulatory accord to spur cross-sector initiatives, reduce conflicting interests and help steer national governance by providing a form of accountability framework.
- fitting the SDGs into the overall business strategy and realistically tailoring it to fit their business models and resources. This is has been implemented through CSR principles, corporate governance and risk management systems. For instance, by regularly analysing their “financial value-chain”, financial institutions can ensure that they are complying with anti-money laundering and counter-terrorism financing (AML/CTF) laws.
- Implementing corporate governance mechanisms at different levels of their organisations while fostering personal and corporate ownership of sustainability principles. This has been evidenced through voluntary regulations, social norms and expectations, professional ethics and best practices. This will go along way in reducing white-collar crime headlines and enhancing reputational crisis management.
Generally, the financial services sector is considered non-polluting,but risk management issues and stakeholder pressure impels them to move in a more sustainable direction. Unless stakeholders in the financial services sector factor in environmental, social and governance (ESG) concerns into their corporate planning cycle, financial institutions are likely to experience:
- reduced cashflows for firms’ securities held in tainted portfolios and lower future dividends;
- lower productivity among their staff
- higher input costs such as taxes, levies and insurance premiums
- increased uncertainty has led to increased volatility in the capital markets as externalities accumulate and are not factored into the market prices
- depleted natural resources and reduced cashflows to the economy leads to reduced asset base of financial institutions.
The Kenyan Scenario
Kenyan financiers can mitigate these ESG related costs by viewing sustainability from a risk mitigation perspective through client engagement and effective risk management policies and procedures. This is of importance as the banking industry is a key player in the Kenyan economy, not only because of its financial intermediation, inclusion and deepening roles but also a key employer and as one of the highest taxpayers should factor the aforementioned in decision making. This was evidenced by reactions of the capital and inter-bank markets following the more recent collapse of three Kenyan banks in 2015/6 as well as the Banking Amendment Act 2016 which forced stakeholders to revisit sustainability principles.
Apart from introducing the Kenya Sustainable Finance Principles and Guidelines, the financial sector is reducing systemic risk by implementing Basel II (the second international banking regulatory accord) coupled with a few elements of Basel III. The latter was introduced as after the financial crisis to not only bring some form of prudence in corporate governance mechanisms but also strengthen the previous micro-prudential regulations as well as introduce macro-prudential regulations².
Moreover, financiers have been active in corporate philanthropy primarily through their foundations but there is need for them to move beyond the ‘low-hanging fruit’ by integrating sustainability in their products, processes and planning. Further, they should actively measure and report the outcomes on both their financing and non-financing activities. Whether a firm likes or not, reports reflect company culture and shed light on the areas in which the firm needs to change by being either a mirror or a window.
While Kenyan financial institutions are eager to embrace sustainability principles, they face great implementation challenges in incorporating them into their business models and eventually reporting structures for four reasons:
- First, sustainable finance not only entails considering environmental, social and governance (ESG) values in project finance but also addresses financial inclusion for the borrowers who are considered part of the missing middle–micro, small and medium enterprises (MSMEs) who do not have access to the next stage of financing. Consequently, these present numerous opportunities as well as potential risks for credit providers such as liability, collateral, credit and reputation which may have rippling effects on stakeholders’ interests in terms of cash flow stability, debt serviceability, asset value and sustainable profitability. Hence a large percentage of sustainable finance universe is unlabelled, unreported and does not enjoy associated benefits. Moreover, in the current interest-rate capping regime, banks are even more risk-averse tin extending credit to businesses that have high risk profiles despite their sustainable benefits.
- Second, most financial institutions focus on traditional risk management methods that give importance to tangible uncertainties which may create a risk glass ceiling that prevents circulation of important information. This, in turn, could blind the employees and management from noticing the non-financial risks and be caught flat-footed when the risks materialise. By incorporating corporate sustainability agenda in their business models, financial institutions can mitigate some of these risks.
- Third, financial risk measurement has been challenging for accounting officers across all sectors mostly for two reasons. Some risk professionals still consider non-financial risk as a misnomer as their intangible value is difficult to measure. Accounting officers face difficulty in quantifying and distinguishing the effect of corporate sustainability issues on the overall tangible performance of a business. They may have limited understanding and management of the ESG risks and impact. Also, they may lack adequate skills to enable them to understand the implications of direct and indirect costs. Moreover, lack of co-ordination across cross-functional teams may impede the adoption of sustainable practices. Moreover, there are limited key performance indicators to verify the progress in ESG risk management. Constructing financial reports requires professional judgements to be made as the more principled-based the framework, the more outcomes relies on professional opinion. Hence these reports can either be viewed as instruments of objective evaluation or as a set of professional judgements relating to a unique decision.
- Fourth, most organisations cast their long-term strategy for 3–5 years while some sustainability strategies require more than five years for tangible results to be noticeable such as installing motion sensors or going paperless or working remotely in order to build rapport with their stakeholders.
- Lastly, various global initiatives such as Global Reporting Initiative (GRI) and International Integrated Reporting Council (IIRC) have been on the forefront in providing guidance on reporting frameworks and standards with the aim of increasing visibility of organisational efforts and accountability. Mandatory regulation such as the Basel III are also a challenge as some scholars have noted that Basel III does not explicitly address sustainability issues particularly systemic environmental concerns. But these initiatives and requirements have been quite challenging to adopt for some financial institutions especially in developing countries (and even some developed countries) due to the resource commitment and the institutional frameworks.
By embedding sustainability into the reporting process, both employees and employers are empowered by their role in creating a legacy through documenting the company’s contribution and its evolution over the years. This also provided case studies for other financial institutions in the path of sustainable risk management.
In short, the financial industry can no longer bury its head in the sand on sustainability issues when it has already been served several wake-up calls to actively take up it fiduciary duties and balance its risk-return trade-offs.To paraphrase the Good Book, “…Great gifts mean great responsibilities; greater gifts, greater responsibilities…” and even greater opportunities.
References:
- KBA (2015) Kenya Sustainable Finance Principles and Guidelines. Nairobi:Kenya Bankers Association
- Nyantakyi, B.E. and Sy, M. (2015). The Banking System in Africa: Main Facts and Challenges. Africa Economic Brief, 6(5). Tunis: African Development Bank
Additional Reading:
Lauesen , L.M. (2013). CSR in the Aftermath of the Financial Crisis. Social Responsibility Journal. 9(4) pp.641–663, doi: 10.1108/SRJ-11–2012–0140.
Disclaimer: All views expressed here do not necessarily reflect the opinions of my employers or clients, past or present.
