The present analysis explores the impact of the environmental, social, and governance (ESG) bonds on the lending practices and policies of Romanian banks and their corporate clients. ESG bonds are bonds that finance projects and activities (through sub-loans) that have positive environmental, social and governance outcomes. The study focuses on the ESG bonds issued by Romanian banks for corporations and analyzes how they affect the bank-client relationship, the corporate governance and the sustainability performance of the borrowers. The study looks for the potential emergence of a atypical new lending product that combines ESG bonds with specific conditions and incentives for the eligible clients. Our analysis investigates in what ways does the lending behavior and relationship of the Romanian banks and their corporate clients change as a result of the use of proceeds restrictions and incentives from restrictions in the ESG bonds program. We plan to answer this question by doing a qualitative and quantitative analysis of the ESG bonds that Romanian banks have issued.
The European Union has adopted a series of ambitious policies and legal instruments to promote sustainable finance and to support the transition to a low-carbon and socially inclusive economy. The Sustainable Finance Disclosure Regulation1 (SFDR), the EU Taxonomy Regulation,2 and the EU Green Bond Standard3 are some of the key initiatives that aim to mobilize public and private capital for green, social, and sustainable projects. These projects are expected to contribute to the achievement of the EU’s environmental and social objectives, such as climate change mitigation and adaptation, biodiversity protection, circular economy, social inclusion, and human rights.
One of the main challenges for sustainable finance is to ensure that the funds raised for green, social, and sustainable purposes are effectively allocated to eligible projects and activities that generate positive environmental and social impacts. This requires a robust framework for defining, measuring, reporting, and verifying the sustainability performance and outcomes of the projects and activities financed by sustainable financial instruments. Moreover, it requires a high level of transparency and accountability from the issuers and intermediaries of such instruments, as well as from the beneficiaries and end-users of the funds.
However, with the emergence of the new legislative package as well as new ESG linked instruments, we have identified the possible emergence of a new type of atypical financial instruments, in particular in the emerging markets of the EU. Our analysis focuses primarily on the financial market of Romania, using it as a case study for the preliminary analysis of this atypical instrument.
We focus on a specific type of sustainable financial instrument: the environmental, social, and governance (ESG) bonds. These instruments are bonds that raise funds for projects and activities that have positive environmental, social, and governance impacts, such as green, social, and sustainable bonds. We explore the impact of ESG bonds on the evolution of banks’ lending activity, especially in the context of an emerging financial market such as the one in Romania.
We investigate the potential emergence of an atypical new lending product, relating to the use of proceeds restrictions and incentives derived from the ESG bonds. We also examine the implications of this product for the corporate governance practices of the borrowers, as well as for the bank-client relationship. The scope of this study is limited to the ESG bonds issued by Romanian banks that target eligible projects and activities for corporations. Therefore, we exclude from our analysis the ESG bonds that are intended for retail products, such as green mortgages or green consumer loans. We focus on the main characteristics of the ESG bonds issued by Romanian banks, such as the definition and identification of eligible projects and activities, the alignment with the European and international standards and frameworks, the reporting and verification of the use and impact of proceeds, and the potential benefits and drawbacks for the bank-client paradigm.
The present study is part of a broader research project that aims to anticipate and determine the potential risks associated with the use of proceeds from ESG bonds by Romanian banks. The project examines the implications of ESG bonds for the lending practices and policies of the banks, as well as for the corporate governance and sustainability performance of the borrowers. The project also explores the possible emergence of this atypical new lending product that combines the features of ESG bonds with specific conditions and incentives for the eligible clients.
The main research question that guides our analysis is: how do the use of proceeds restrictions and incentives derived from the ESG bonds affect the lending behavior and relationship of the Romanian banks and their corporate clients? We aim to answer this question by conducting a qualitative and quantitative analysis of the ESG bonds issued by Romanian banks.
What we generically define as ESG bonds is an umbrella term, referring to all debt instruments that raise funds for projects and activities that have positive environmental, social, and governance impacts. They can be issued by governments, banks, or corporations, and they align their instrument with European or international standards for green, social, and sustainable bonds. These principles provide voluntary guidelines for the issuers of ESG bonds, covering four core components: (i) the use of proceeds, (ii) the process for project evaluation and selection, (iii) the management of proceeds, and (iv) the reporting on the allocation and impact of proceeds.
The use of proceeds is the key feature that distinguishes ESG bonds from conventional bonds. The issuers of ESG bonds commit to allocate the proceeds to eligible projects and activities that have positive environmental, social, and governance impacts. The issuers also disclose the criteria and methodology for selecting and evaluating the eligible projects and activities, as well as the expected environmental and social benefits and outcomes.
The management of proceeds refers to the tracking and monitoring of the allocation of proceeds to the eligible projects and activities. The issuers of ESG bonds establish a separate account or a sub-account for the proceeds or use other methods to ensure the traceability and verification of the funds. The issuers also report on the allocation and impact of proceeds, providing information on the amount, category, location, and performance indicators of the projects and activities financed by the ESG bonds.
Romania is an emerging financial market that has witnessed a significant growth of ESG bond issuance in recent years. The main drivers for the issuance of ESG bonds in Romania are both legislative and market based. On the legislative side, the EU regulations and guidelines on sustainable finance, such as the SFDR, the EU Taxonomy Regulation, and the EU Green Bond Standard, create a strong incentive for banks and other issuers to align their funding strategies with the EU’s environmental and social objectives and to disclose their sustainability performance and impact. Moreover, the implementation of the green asset ratio (GAR) requirements4 of the SFDR, which measure the share of banks’ exposures that are environmentally sustainable, and the compliance with guidelines on sustainable financing, which provide a common framework for banks to identify, assess, and manage ESG risks, also incentivize banks to issue ESG bonds and to greenify their loan books.
On the market side, the investors in ESG bonds, especially institutional investors, such as pension funds, insurance companies, and asset managers, are looking for specific requirements and incentives in the sub-loans that result from the use of proceeds of the ESG bonds. These may include side letters, green frameworks, or other contractual arrangements that ensure the alignment of the sub-loans with the ESG bond principles and standards. Moreover, the market pressure for sustainable finance is also driven by the availability of predominantly sustainable bank financing, due to the impact of ESG requirements on institutional investors, and by the link between the minimum requirement for own funds and eligible liabilities (MREL) and sustainable funding sources, which aim to enhance the resilience and stability of the banking sector.
The issuance of ESG bonds by banks has a significant impact on the bank-client relationship, as it imposes certain restrictions and incentives on the use of proceeds and on the eligibility of the projects and activities financed by the sub-loans. Moreover, it also affects the corporate governance practices of the borrowers, as it requires a higher level of transparency and accountability on their ESG performance and impact.
In this section, we explore the potential emergence of an atypical new lending product in the Romanian market, based on the use of proceeds restrictions and incentives derived from the ESG bonds, and we analyze the implications of this product for the bank-client relationship and the corporate governance practices of the borrowers.
The first element of the emergence of the atypical finance product comes from the type of funding. The ESG bonds issued by banks earmark the sources of funding for green, social, and sustainable projects and activities that are eligible for financing, according to the ESG bond principles and standards. This means that the banks must select and evaluate the projects and activities of their clients based on specific criteria and methodology, and to allocate the proceeds of the ESG bonds accordingly. The banks also must report on the allocation and impact of the proceeds, and to ensure the traceability and verification of the funds. This implies that the banks have to monitor and supervise the use of proceeds by their clients on an ongoing basis, and to ensure that they comply with the ESG bond requirements and objectives (either project-specific or at entity level, depending on the type and structure of the debt instrument).
The second element is the ESG screening of the corporation. The ESG bonds issued by banks can not only target the projects and activities of their clients, but also the overall ESG performance and impact of the borrowers. This means that the banks must assess and manage the ESG risks and opportunities of their clients, and to integrate ESG factors into their credit risk analysis and decision-making process. The banks also have to disclose their ESG risk policies and procedures, and to comply with the EU regulations and guidelines on sustainable finance. This implies that the banks have to conduct a comprehensive and holistic ESG screening of their clients, and to ensure that they meet the ESG standards and expectations of the ESG bond investors as well as national competent authorities.
The third element, and perhaps the crucial accelerator of the atypical financial product, is the restrictions and incentives on the sub-loans and covenants. The ESG bonds issued by banks may also entail certain restrictions and incentives on the terms and conditions of the sub-loans and covenants that result from the use of proceeds of the ESG bonds. These may include lower interest rates, longer maturities, preferential collateral, or other financial benefits for the borrowers that comply with the ESG bond requirements and objectives. They may also include contractual terms and conditions that impose specific obligations or sanctions on the borrowers regarding their ESG performance and impact, such as reporting, disclosure, verification, or assurance duties, or governance and strategy changes, or default or penalty triggers. These imply that the banks have to negotiate and enforce the sub-loans and covenants with their clients, and to ensure that they create value and mitigate risks for both parties.
The issuance of ESG bonds by banks also has a significant impact on the corporate governance practices of the borrowers, as it requires a higher level of transparency and accountability on their ESG performance and impact. We thus propose that these three elements have shaped a new atypical financial instrument, as seen in Diagram no. 1. While shaped as a sub-loan (part of the ESG bond financing structure), the lending agreement allows the bank to impose ESG and, in particular, governance restrictions on lenders, blurring the line between lender and shareholder, giving (indirect) control rights to the bank to shape the strategy and governance of the corporate client.
Based on the discussion of the previous chapter, we can start considering the possibility of a new type of stewardship role for the banks, as they have to monitor and supervise the use of proceeds and the ESG performance and impact of their clients, and to intervene and influence their governance and strategy decisions, if necessary.
However, how likely is it that banks would actively intervene? The answer is country specific and depends on the growth and maturity of the governance practices existing in the market. We hypothesize that corporations with less robust governance structure, like those from emerging markets, might be more vulnerable and might require stronger interference from banks. In this section, we examine the specificity of corporate governance practices in Romania, and we analyze the level of interference and the risks and opportunities of the banks in this new stewardship role.
According to the Climate Bonds Initiative,5 Romania ranked 12th in Europe and 25th globally in terms of green bond issuance in 2020, with a total volume of EUR 1.6 billion, relatively a small player in the ESG debt market. However, the main issuers of green bonds in Romania were banks, accounting for 81% of the total volume, followed by corporations (15%) and municipalities (4%).6 So, this market is more prone to the emergence of the ESG atypical financial product because the ESG bond market is primarily bank driven, which has strong incentives to quickly place the sub-loans and generate new assets in order to show a level of additionality to its investors.
The specificity of corporate governance practices in Romania is characterized by a strong gap between the top performers and the rest of the market. According to the Vektor indicator,7 which ranks the disclosure and governance practices of the listed companies on the Bucharest Stock Exchange, the average score for 2022 was 4.4 out of 10, decreasing from 4.9 in 2021. The average drops to 2.7 after removing the top performers from the BET index, which includes the most liquid and representative companies. The governance practices, excluding disclosure, scored even lower, with an average of 29.9%. For the premium companies, the governance score was 59%, while for the lower tier performers, the score dropped to 13%. For the SME market, called AeRO, the average score for 2022 was 5.3 out of 10, with divergent results.8
However, we also hypothesize that the level of interference of the banks in the corporate governance practices of their clients may vary depending on the scenario and the strategy adopted by the banks. We identify three possible scenarios, based on the preliminary results of our research interviews with ESG leads in the top five banks in Romania, which have also issued ESG bonds.
The first scenario is a simple check of the ESG score of the client, with no knockout or disqualification condition for the loan, as the ESG score only provides insight into the overall risk score. The second scenario is a focus on disclosure requirements, imposing duties only to disclose, without inserting covenants for governance or social conditions, with links to loan default mechanism. The third scenario is a requirement of changes to both disclosure and governance practices, to ensure compliance with legal and contractual requirements for banks, and to align with the ESG bond principles and standards. The third scenario would be the one which generate the activation of the atypical financing product.
What are then the risks and opportunities of the banks if they deploy a scenario three, atypical ESG lending product? The risks are related to the management of information asymmetry, moral hazard, reputational risk, and liability risk. The banks have to manage the information asymmetry and moral hazard issues that arise from the use of proceeds and the ESG performance and impact of their clients, and to ensure that they have the resources and expertise to intervene and influence their governance and strategy decisions, if necessary.
The banks also have to manage the reputational risk that stems from the ESG bond issuance and the alignment with the ESG bond principles and standards, and to avoid the accusations of greenwashing or social washing, which may damage their credibility and trustworthiness. Furthermore, the banks have to manage the liability risk that may result from the damage caused by their interference or negligence in the corporate governance practices of their clients, and to avoid the sanctions or lawsuits that may arise from the breach of legal or contractual obligations. For example, according to art. 169 of the Romanian Insolvency Law,9 any persons who have contributed to the debtor’s insolvency can be made liable to creditors under the insolvency regime. If the bank is operating as a steward/shadow shareholder/director and its restrictions on governance and strategy can be linked to the insolvency outcome, there is a liability risk for the credit institution.
In this article, we have explored the impact of ESG bonds on the evolution of banks’ lending activity, especially in the context of an emerging financial market (i.e., Romania). We have investigated the potential emergence of an atypical new lending product, relating to the use of proceeds restrictions and incentives derived from the ESG bonds, and we have analyzed the implications of this product for the bank-client relationship and the corporate governance practices of the borrowers. We have also examined the specificity of corporate governance practices in Romania, and we have analyzed the level of interference and the risks and opportunities of the banks in their stewardship role, based on the country specificity.
We have found that the issuance of ESG bonds by banks has a significant impact on the bank-client relationship, as it imposes certain restrictions and incentives on the use of proceeds and on the eligibility of the projects and activities financed by the sub-loans. Moreover, it also affects the corporate governance practices of the borrowers, as it requires a higher level of transparency and accountability on their ESG performance and impact. We have also found that the level of interference and the risks and opportunities of the banks in their stewardship role may vary depending on the scenario and the strategy adopted by the banks, and that the banks have to manage the information asymmetry, moral hazard, reputational risk, and liability risk that arise from their role.
We have identified three possible scenarios for the level of interference of the banks in the corporate governance practices of their borrowers, depending on the extent to which they impose restrictions and incentives on the use of proceeds and the eligibility of the projects and activities financed by the sub-loans. We have argued that the scenario which involves requiring changes to both disclosure and governance practices may lead to the emergence of an atypical lending product that combines financial and non-financial covenants and gives the banks a stewardship role over their clients. We have also discussed the risks and opportunities of this scenario for both the banks and the corporations, as well as the implications for the stakeholder value and the enlightened creditor value.
However, our research has some limitations that need to be acknowledged and addressed in future studies. First, our sample size is relatively small and may not be representative of the whole banking sector in Romania or other emerging markets. Second, our analysis is mainly qualitative and does not provide empirical evidence on the actual impact of ESG bonds on the bank-client relationship and the corporate governance practices of the borrowers. Therefore, we suggest some directions for further research that can overcome these limitations and extend our findings.
One direction is to conduct a larger and more systematic survey of all Romanian banks, regardless of their ESG bond issuance, and compare their ESG screening practices, their use of proceeds restrictions and incentives, and their level of interference in the corporate governance of their borrowers. This would allow us to test the validity and generalizability of our scenarios and to identify the factors that influence the banks’ choices and strategies.
Another direction is to collect and analyze quantitative data on the ESG performance and impact of the borrowers that receive sub-loans from the ESG bond proceeds, and to compare them with those that do not. This would allow us to measure the effectiveness and efficiency of the use of proceeds restrictions and incentives, and to assess the extent to which they lead to positive governance outcomes. Moreover, it would enable us to evaluate the costs and benefits of the banks’ interference in the corporate governance of their borrowers, and to examine the trade-offs and synergies between the financial and non-financial objectives of the bank-client relationship.
By pursuing these directions, future research can provide a more comprehensive and nuanced understanding of the impact of ESG bonds on the evolution of bank lending, especially in emerging markets, and can offer practical and policy implications for the banks, their clients, and the society at large. n
