The Brazilian banking system is preparing for new ESG regulations

Markers that measure the water level stood at a historically low level at the reservoir near Jaguari Sao José dos Campos in the state of Sao Paulo, Brazil, Thursday, November 13, 2014.

Credit: Paulo Fridman/Bloomberg via Getty Images

In 2014, the state of São Paulo, the most populated region in Brazil and one of the most urbanized areas in Latin America, experienced a historic drought for more than two years.

“We had to take short showers,” said Christopher Wells, global head of environmental and social risk at Banco Santander SA. “It makes you think about life in a very different way.”

Brazilians have had to drastically reduce their water consumption and some companies have considered relocating during the crisis. Wells said the bank believes all of its customers will be affected.

“So we decided to incorporate a water scarcity aspect into our credit risk models,” Wells said.

Banco Santander (Brasil) SA was one of the major Brazilian lenders to incorporate a sustainability rating into its traditional loan analysis. Borrowers with better water treatment, or who were in an area with an abundant supply, could suddenly benefit from a lower rate on their loans.

Seven years and a pandemic later, Brazilian central bank Banco Central do Brasil is strengthening its environmental, social and governance, or ESG, regulatory framework. To do this, it draws up a list of ESG risks that banks will have to integrate into their credit models. In order to adequately manage these risks, banks will need to come up with mitigation and response plans to compensate for losses that may arise from events such as environmental fines, soil contamination, natural disasters or excessive use of resources. .

A first round of prudential regulation is scheduled for July, calling on large and medium-sized banks to review portfolios and outline inherent ESG risks. In addition, they will also have to perform sustainability-focused stress tests that require ESG criteria to be fully integrated into their credit models. A second and final round is expected in 2022, in which banks will have to pass or score with a certain rating.

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The decision to review ESG regulations reinforces the idea that the central bank sees the potential impact of these environmental risks on the overall stability of the system.

COVID-19 has only accelerated global concerns about climate change. Banks must now be particularly careful about exposures to sectors that could be vulnerable to rising temperatures or other effects associated with the transition to a low-carbon economy.

“Banco Central do Brasil was a pioneer in 2014 when it launched rules on these topics,” said David Valente, division head in the central bank’s regulatory department. “After seven years, and with commitments such as the Paris Agreement, we felt it was time to improve regulation.”

Valente explained that the upcoming prudential regulation would take into account potential climate and environmental risks, especially for large projects that develop over a long period. From resorts at risk of being overwhelmed by rising sea levels to fossil-intensive energy companies failing to turn to renewable sources in a timely manner, banks must now consider these criteria when credit risk assessment for their customers.

The central bank will likely urge banks to consider ESG-related risks not only when making loans in sectors such as agriculture, mining, oil and gas, but it will also urge banks to assess these risks at portfolio level.

“What needs to be done now,” explains Santander’s Wells, “is [to] improve portfolio-level analysis and not just company valuations. Are we exposed to a sector that could be strongly impacted by climate change? This is one of the big questions that banks ask themselves.

Itaú Unibanco Holding SA, Brazil’s largest bank, is currently developing tools and a methodology to integrate climate factors into the bank’s risk assessment models, as part of their environmental and social risk rating. Scarcity of data and methodologies is one of the challenges the bank faces in its risk analysis, a spokesperson said.

According to Itaú’s spokesperson, another layer of complexity in incorporating ESG considerations into risk models is working with the inherent uncertainty of assessing multiple scenarios and different time frames in which risks may occur. whether or not to develop.

Exposure to business loans

Business loans represent 18.8% of the total loan portfolio of large institutions. In each new disbursement, sustainability factors already feed into the borrower’s risk analysis.

Santander Brasil, for example, scans around 2,000 companies with annual sales of over 20 million reais. It gives them a sustainability rating that’s built into their lending rates, especially for sectors that require environmental permits, Wells said.

The vast majority of these companies are located in the highly urbanized state of São Paulo and in southeastern Brazil.

Contaminated soils are a problem in the state of São Paulo, since the city of Sao Paulo was an industrial cluster decades ago. Real estate and land, which were typically used as collateral for loans, may require further scrutiny from an environmental perspective.

Since the 2014 drought, water management has also become an increasingly important factor. “We created the system partly with climate change in mind, but also because of real, practical considerations that we were seeing in São Paulo,” Wells said. “Due to the drought, a significant portion of the note is water related.”

“Banks in Brazil, especially the more complex ones, already have self-regulation,” said Carolina Barbosa, adviser at Banco Central do Brasil.

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Agribusiness

Brazil’s agribusiness sector, one of the main recipients of corporate loans, has come under increased scrutiny in recent years. Environmentalists and investors have challenged food companies to use deforested Amazon land to grow cattle or soybeans. For banks, assessing environmental risk means going beyond direct customers, but also targeting their customers’ suppliers.

“Okay, so the factory might be fine. But they’re buying soy or cane or beef. Now what are they doing in terms of suppliers?” says Wells. All of these things add up to their credit score.”

Although lending to the Amazon region accounts for less than 5% of banking portfolios, the region demands great attention from bankers. Despite the small share that these loans represent in their portfolios, banks pay great attention to the risks of damage to reputation that could be linked to environmental issues.

“We spend 30% of our time on Amazon-related issues,” Wells said. Santander vets ranchers and farms and checks whether the bank could lend to a farm that may encroach on indigenous community land or has been illegally deforested.

Strong official data allows banks to effectively trace supply chains, but records on environmental issues are not as abundant. When it comes to greenhouse gas emissions, banks depend on what customers declare in their inventories. “And when they don’t, we have to make an effort to estimate emissions based on financial data,” the Itaú spokesperson said.

Risk and more risk

Social issues also have the potential to disrupt businesses, central bank officials said in interviews. Less than a year ago, the violent death of a black man at the hands of Carrefour security guards in Porto Alegre sparked social protests. Protesters have attacked branches of the supermarket in different parts of the country and the business has been widely condemned.

Another recent example of an unexpected human and environmental catastrophe was the 2019 collapse of the tailings dam at Córrego do Feijão iron ore mine in Brumadinho, where the resulting mudslide claimed the lives of around 270 people and where agricultural land was contaminated. Jhe companies involved had to respond financially with substantial fines.

Among them, mining giant Vale signed a settlement in February for a payment of about $7.02 billion to the state of Minas Gerais to compensate the families of those who died in what is considered one of the worst environmental tragedies in the country’s history. However, groups representing victims later challenged the terms of the settlement.

“Banks should be aware that these risks can materialize,” said the central bank’s Valente. “They will now have a very clear definition of what those risks are and the loan loss events that could be associated with each of them.”

As of June 16, US$1 was equivalent to 5.00 Brazilian reais.

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