Sustainability and bank risk

Banks play a key role in society and are crucial for economic development. The existing literature finds a positive association between bank performance and sustainability, but tends to neglect the risk dimension. As human-driven processes interact with global social-ecological connectivity and exhibit cross-scale relationships, we investigate whether sustainability affects banks' individual default risk and their systemic risk, that is, their contribution to the risk of the financial system. As banks are financial intermediaries and there is no direct measure of their sustainability, we proxy for sustainability with banks' performance on environmental, social, and governance attributes, especially their policies and performance. We control for relevant bank, market and country characteristics. It shows that higher sustainability scores of banks significantly associate with lower default risk. We also establish that outperformance on sustainability reduces banks' contribution to systemic risk. Thus, it appears that banks' sustainability performance can spill over to the financial system. This implies sustainability is material for banks and their supervisors. Accounting for sustainability can augment bank risk management and prudential policy decision making, and provide guidance as to how to finance a transition towards an economic system that effectively internalizes externalities.