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Highlights
- Global regulators are urging financial services organizations to include environment, social, and governance (ESG) factors in their business strategy and other aspects to improve their sustainability posture.
- Introducing ESG parameters into customer due diligence checks such as know your customer (KYC) processes is one way of achieving this objective.
- Financial institutions can incorporate ESG parameters into KYC processing at minimal costs as it involves minor modifications to the existing infrastructure.
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Introduction
Regulators across the globe are encouraging financial institutions to enhance their sustainability score amid rising environmental concerns.
Financial organizations can achieve this by proactively incorporating environmental, social, and governance (ESG) factors and risks into aspects such as business strategy, risk management, internal control frameworks, and decision-making processes. However, banks face challenges in meeting these expectations. A European Central Bank (ECB) report reveals that banks considered 90% of their practices were only partly or not aligned at all with ECB supervisory expectations.
One way of improving their sustainability posture is for financial institutions to introduce ESG factors into know your customer (KYC) processes that are part of the customer due diligence checks. While accomplishing this comes with its own challenges, the business benefits may be worth the effort.
Why ESG in KYC
Introducing ESG requirements as a standalone risk management process will involve complex, data-intensive aspects, requiring huge investments.
We believe that this can be overcome by handling ESG requirements as part of the KYC process by making modifications to existing systems. This means that financial institutions need not invest in new, standalone frameworks and systems for managing ESG risks, which will help save spends on technology, resources, and other inputs.
The overlap between the data collected for KYC processing and ESG evaluation can result in synergies across data analysis and risk assessment. In our view, integrating ESG data collection into the KYC process will reduce the cost and effort involved by 40%-50%, subject to policies and practices followed by individual financial institutions. It will also eliminate multiple requests to customers for information, thereby improving customer experience.
While introducing ESG into KYC may complicate the process and extend the cycle time, it will be beneficial in the long term given ESG risk assessment is now becoming mandatory across geographies.
Impact on the KYC cycle
The KYC process is largely manual and lengthy, despite the adoption of technology solutions.
Banks request customers to submit multiple KYC documents and spend significant time and effort to comprehensively review them. However, despite this, KYC checks for an account or entity are only partially completed during the initial phase of the account opening process. In our experience, a periodic KYC refresh takes anywhere between 90 to 180 days. In such a scenario, embedding ESG checks into the KYC process could further extend the timelines and complicate the process. To overcome this, technology solutions can be deployed to reduce the overall stress in the process. Leveraging technology can help classify customers according to the perceived ESG risk, establish appropriate checks and balances, and channelize maximum effort toward high-risk customers.
Theory to action
KYC and ESG processes remain process and data intensive.
Technology can help segregate customers based on the level of perceived ESG risk and establish separate workflows. This will ensure that time and effort are spent only on high-risk customers. Furthermore, automation can enable banks to obtain more accurate KYC and ESG data from publicly available reports. Additionally, financial institutions can consider partnering with external data vendors to access data on KYC and ESG parameters as well as leverage their expertise in data management, collection and validation, analytics, and integration. This will enhance the KYC risk rating exercise by providing banks with a comprehensive view of the ESG profile of prospective customers.
Financial institutions can introduce ESG factors into KYC processes by introducing minor modifications to the existing KYC infrastructure, with minimal impact on costs and resources.
- Negative screenings: As part of the KYC checks, financial institutions must perform negative screening related with ESG aspects to identify customers involved in high-emission activities and those associated with industries amenable to physical and transition risks. Thresholds such as ‘no lending to businesses that earn over 50% of their total revenue from thermal coal’ or ‘no lending to businesses impacting biodiversity’, and so on can be introduced. Financial institutions should chalk out a time-bound plan of action for customers with poor scores in negative screenings, which must include termination of relationship, obtaining additional compliance and risk mitigation declarations, and continuous monitoring to ensure corrective action is initiated.
- ESG risk rating: Financial institutions must evaluate the data collected as part of the KYC process and assign ESG risk ratings, categorizing customers into high, medium and low risk from a sustainability lens. Based on such categorization, financial institutions must recommend course correction strategies to their customers which can include additional compliance mandates and ESG mitigation actions. Additionally, financial institutions must periodically repeat due diligence checks to assess the changes in customers’ risk levels. Similarly, this method can be used to measure the ESG or sustainability risk of a portfolio at a given point of time as well as the change in risk levels over a specific period.
- Risk modeling: Climate change, transition risks, labor policies followed by a customer, governance mechanisms, and management decisions among others impact a company’s operations, and often result in sustainability risks. Categorizing customers as high, medium, and low risk from a sustainability standpoint and considering ESG parameters in credit risk modelling and assessment help in measuring a company's long-term resilience in turn resulting in better credit decisions.
For financial institutions, efficiently managing sustainability risk has emerged as an urgent imperative. And they can up their sustainability quotient by incorporating ESG into KYC processes through specific cost-effective modifications to the existing KYC infrastructure. Are you interested?
