Recent ESG-benchmark abandonment by major U.S. banks along with investment firms retreating from climate risk messaging has come amid two-plus years of political counter-messaging against the environmental, social and governance strategy that the finance industry had embraced.
Despite heated debates around these issues and the high potential costs of these pledges, little has been known about the effectiveness of these commitments in addressing change, says Assistant Professor of Finance Pablo Slutzky at the University of Maryland’s Robert H. Smith School of Business.
This raises questions. To what extent does the shift towards (or away from) the rationing of capital to specific firms affect these firms’ controversial practices? Do these firms change their practices (i.e., not prioritizing safeguarding the environment, as well as fair and equitable relationships with employees, suppliers, customers, and communities)?
New research co-authored by Slutzky provides some answers: “Our paper looks at whether banks that reduce lending to firms in industries that arguably generate negative externalities have any impact on these firms’ operations, and we find that they don’t.”
Furthermore, “while some banks cut lending to these firms, these firms manage to secure loans from other banks, and, somewhat surprisingly, under the same terms such as amounts, interest rates… In summary, our paper finds that the action of a bank or a subset of banks does not impact the operations of these firms,” Slutzky says of “Defunding Controversial Industries: Can Targeted Credit Rationing Choke Firms?,” co-authored with André F. Silva of the Federal Reserve Board, Rice University’s Kunal Sachdeva and University of Rochester’s Billy Y. Xu.
A key point of reference by the authors is Operation Choke Point, the controversial 2012-2017 initiative led by the U.S. Department of Justice, which compelled a not-openly disclosed subset of banks to limit relationships with firms in certain industries that operated legally but that were believed to pose a high risk for fraud and money laundering. Such industries included ammunition, firearms, tobacco, dating and escort services, pornography and online gambling.
Slutzky and his colleagues analyzed supervisory loan-level data collected to support the Dodd-Frank Act’s stress tests and assess bank capital adequacy for the largest banks, which also includes firm-level information. They also analyzed court documents that followed the lawsuits initiated by firms in affected industries to better understand how the targeting of banks worked. This allowed them to explore the dynamics of banking relationships and the provision of credit.
As an ‘ESG comparison,’ they describe Operation Choke Point as a “near-ideal quasi-random experiment to study the causal effects of targeted credit rationing on firms’ operations.”
Credit rationing did affect banking relationships, Slutzky says. “Banks targeted by Operation Choke Point reduced lending and terminated relationships with firms in affected industries. However, these firms for the most part initiated new relationships with non-targeted banks and managed to fully substitute credit, offsetting the intended effect of the initiative.”
He adds: “This dynamic – whether via Operation Choke Point or the Equator Principles for project financing (a pillar of the ESG-focused rationing) – undercuts the intent of targeted bank rationing of firms.”
