Did ESG Cause SVB to Collapse? BMO Equity Research Report

Doug Morrow:

It's clear that SVB's sustainable finance commitment was much less ambitious than what we're seeing in other parts of the US financial services ecosystem. So again, it just kind of reinforces this idea that the collapse was more a function of inadequate risk controls than climate financing or ESG practices.

Michael Torrance:

Welcome to Sustainability Leaders. I'm Michael Torrance, chief sustainability officer with BMO Financial Group. On this show, we will talk with leading sustainability practitioners from the corporate, investor, academic, and NGO communities to explore how this rapidly evolving field of sustainability is impacting global investment business practices and our world.

Speaker 3:

The views expressed here are those of the participants and not those of Bank of Montreal, it's affiliates, or subsidiaries.

Michael Torrance:

Today I'm joined by Doug Morrow, director of ESG strategy on BMO's Equity Research team. Doug just published a report on Silicon Valley Bank, SVB, and the emerging narrative on whether ESG distracted from the bank's core business and led to its eventual collapse. Doug and his team analyzed these claims head-on evaluating SVB's ESG approach and whether it contributed to the bank's failure.

Doug, I'm really excited to chat with you about this. It's really interesting to me that you took a very rigorous approach to this question and actually investigated these kinds of claims. Can you tell me about the research that you've done in relation to whether SVB failed because of some wokeness as is sometimes called or ESG strategy of the bank and what your findings were?

Doug Morrow:

Sure. Well, thanks very much for having me back, Michael. It's a real pleasure to be here. And as far as SVB goes, unfortunately I think what happened was that the bank got caught up in the politicization of ESG that's taking place in the US. So what we saw was that within a few days of the bank's failure, we started to see this narrative develop that SVB had failed because management was too focused on priorities like sustainable finance or diversity equity and inclusion, or other ESG priorities. I think the dust has settled, and I do believe this narrative has been mostly debunked, but it really shows just how politically charged ESG has become in the US.

So as we said in our note, the facts are that SVB collapsed because of what we would characterize as a lumpy deposit base, which was highly skewed to uninsured deposits and long-term treasury bonds. Basically this caught up to the bank when interest rates began rising through unrealized losses under market to market market accounting rules. So in our view, that is what eventually led the bank to collapse. It was about poor risk management and inadequate risk controls. So I do think it's a real stretch to say that these mistakes were made because management was too busy trying to meet ESG goals, which was part of the narrative that kind of came out after the failure.

Now, to be fair, I do think SVB definitely had a unique culture and what I would call a determined ESG strategy. They certainly had ambitious diversity goals. They were known as a climate bank. They provided a ton of financing to smaller clean tech and green tech companies, they had over 1,500 customers doing climate and sustainability work, but they had been successfully using that model for decades. So again, I think it does come down to inadequate risk controls and the sudden change in the interest rate environment, not the bank's book of business with the climate community or it's ESG commitments in my view.

Michael Torrance:

You mentioned that SVB was known as a financier of clean tech, but part of your research also concluded that actually their sustainable finance commitments and achievements were actually lower than the industry. Can you elaborate on some of the quantitative analysis you did?

Doug Morrow:

Sure. So one expression of a bank's ESG approach is its commitment to sustainable finance. This means facilitating and mobilizing loans and financing for companies that are, for example, providing sustainable solutions, aligning against the SDGs, working on energy transition, et cetera. It's not the only ESG line item that investors look at or should look at when they assess a bank, but it's definitely an increasingly important one.

So what we did in the thrust of our note is we just crunched the numbers. What we found was that SVBs sustainable finance commitment turned out to be about 2% of its total assets. That's as of December 31 of last year. So they had made a commitment to achieve $5 billion in sustainable finance by 2027 against total assets of 212 billion. So this is well, well below the percentage that we see for the major Wall Street banks. So for example, Morgan Stanley's sustainable finance commitment of $1 trillion by 2030 is about 84% of total assets, and JP Morgan's is 68%, Bank of America's is 49%. So to be fair, these commitments do stretch out to 2030, whereas SVBs was a little closer to home at 2027. But still it's clear that SVB's sustainable finance commitment was much less ambitious than what we're seeing in other parts of the US financial services ecosystem. So again, it just kind of reinforces this idea that the collapse was more a function of inadequate risk controls than climate financing or ESG practices.

Michael Torrance:

One thing that I thought was a really important observation though in your analysis was the evolving views on ESG, how we understand each of those categories and how we can't lose sight particularly on the G, the governance aspect in considering an overall assessment of sustainability. This is one of the things I've noticed a real evolution in even just the last couple of years where the integration of ESG into core business practices is really the major development in recent years in terms of the rigor in which we think about ESG. There's of course ESG scores and ratings that come out. Different raiders may put different emphasis on the different categories. Perhaps sometimes there's equivalency drawn between them when maybe they're ought not to be from a risk management or other perspective. Can you elaborate on what you concluded in terms of the role of G in ESG and what this situation tells you about maybe how we ought to be considering ESG and also maybe the future of how ESG should be evaluated?

Doug Morrow:

Mm-hmm. Yeah, so this is probably the most ironic thing. So the narrative was that SVB collapsed because it was too woke or too ESG, but maybe it wasn't ESG enough. What I mean by that was that it's clear that there were some governance irregularities with SVB. Again, Michael, this dovetails with what you said in the intro. A point that we've been making in our research for a long time now is that it's important not to forget about the G in ESG is interwoven everywhere.it may not always command the same attention as large environmental or social issues such as climate change, but really if you look the behind the scenes, G is interwoven into how a company manages E&S risks and opportunities.

So a critical part of any well governed company is effective risk management and oversight. However, it came out in the days following SVBs failure that the company had been operating without a chief risk officer for much of 2022 and into 2023. And this was definitely unusual. In fact, the Federal Reserve had identified this as a problematic governance practice long before the collapse. So would that by itself have led some investors to bypass SVB as an investment? I'm not sure, but it should definitely have been seen as a red flag.

Another G issue that has received a lot of scrutiny as the dust has settled was SVB's board composition. So by anyone's standard, SVB had a highly diverse board. We've seen some questions pop up about whether despite this diversity, whether there was sufficient banking industry expertise. So I think that's a really interesting question, but I certainly don't believe that diversity from the perspective of women on the board or BIPOC representation on the board contributed to the bank's collapse. I think it's crucial for boards to have diverse representation, and we should be thinking about board diversity from the perspective of an and, not an either or. So in other words, it's about finding competent experience and diverse viewpoints.

Michael, there's another issue here that you touched on, and that's the role of ESG ratings. So despite any governance issues that the company had, it still had a generally favorable ESG rating from MSCI and Sustainalytics. These are far and away the two biggest players in the market and the most important in my opinion. So MSCI had them at a single A and Sustainalytics had them at 28.4 on their framework. I wouldn't say these are brilliant ESG ratings, but they're definitely investible and definitely skewed towards the better end.

The data also show, as we pointed out in our note, this is based on Morningstar numbers, that ESG funds appear to have been marginally overweight SVB relative to conventional funds. So they had a average allocation of 0.33% of their assets held in SVB equity. This compares to 0.29% for conventional funds, so slightly overweight. So again, I think this shows that many ESG funds were quite happy to hold SVB irrespective of any governance issues. This is what we mean when we say that ESG scores can create a full sense of precision. They've been extraordinarily successful in facilitating ESG integration, but investors still need to do their homework.

Michael Torrance:

So Doug, if there was a case study at a business school on SVB and you're teaching ESG or sustainable finance, what would you sum up as the key takeaways and lessons learned from this situation?

Doug Morrow:

Well, when I reflect on it, my first thought to be honest, is that there's a big hole in the market right now for climate financing in the US, which clearly creates opportunity. But when I reflect on the lessons, I mean, I think it's crucial for banks and indeed any company not to lose sight of the significance of risk management and basic risk management protocols. They may not always get the attention of other parts of the enterprise, but risk management is obviously an essential function. The importance cannot really be overstated, especially in times of periods of market volatility. So clearly, that's one takeaway.

I also think that SVBs failure is going to raise the market's interest in assessing firm culture. As I said at the opening, it was definitely the case that the bank had a unique culture, particularly compared to its Wall Street peers. Firm culture is difficult to measure. It's not a line item. You cannot observe it on a balance sheet, an income statement, cash flow statement, but it's clear that it can play an important role in how a company competes and it can have effects on financial performance. So I think you're going to see more dialogue coming out of this about how we think about firm culture.

And then from an ESG perspective, I think it's pretty clear that this failure is going to put more scrutiny on ESG funds and their selection methodologies and also the role of composite ESG scores. So just because a company is excelling on environmental practices doesn't mean it necessarily has excellent labor practices or health and safety practices or incentive structures. It's interesting because when I first started in the responsible investing world, this is going way back... I'm really going to date myself here, but this is going back to 2004, much more attention was paid to ES&G inputs. But somewhere along the line, I would say maybe roughly in 2017 when ESG really started to take off, we had the tailwinds from the Paris Agreement just being signed, composite scores became commonplace. I think that this collapse from SVB shows that it will always be important for investors to look under the hood and do a deep dive on each of these pillars.

Michael Torrance:

Thank you, Doug, for that very thoughtful analysis. It's very interesting and timely. So thanks for your time today.

Doug Morrow:

My pleasure.

Michael Torrance:

Thanks for listening to Sustainability Leaders. This podcast is presented by BMO Financial Group. To access all the resources we discussed in today's episode and to see our other podcasts, visit us at bmo.com/sustainabilityleaders. You can listen and subscribe free to our show on Apple Podcasts or your favorite podcast provider. We'll greatly appreciate a rating and review and any feedback that you might have. Our show and resources are produced with support from BMO's marketing team and Puddle Creative. Until next time, I'm Michael Torrance. Have a great week.

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The views expressed here are those of the participants and not those at Bank of Montreal, its affiliates, or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, strategy, or security. This presentation may contain forward-looking statements. Investors are cautioned not to place undue reliance on such statements as actual results could vary. This presentation is for general information purposes only and does not constitute investment, legal, or tax advice, and is not intended as an endorsement of any specific investment product or service. Individual investors should consult with an investment, tax, and/or legal professional about their personal situation. Past performance is not indicative of future results.