Responsible investment research: Bank climate risks
Biased ESG ratings: Do Commercial Ties Influence ESG Ratings? Evidence from Moody’s and S&P by Xuanbo Li, Yun Lou, and Liandong Zhang as of Oct. 25th, 2022 (#398): “… we use Moody’s (S&P’s) acquisition of Vigeo Eiris (RobecoSAM) as a shock to firms’ commercial ties with the ESG rating agency. We find that after the acquisition, firms that have existing credit rating business with Moody’s and S&P receive higher ESG ratings than those that do not. The increase in ESG ratings is more pronounced for firms that have more intensive credit rating relationships with Moody’s (S&P) and firms that issue green bonds. … the ESG rating quality appears to deteriorate after the acquisitions and investors are unable to fully see through the inflated ESG ratings. Finally, there is some evidence that the upwardly biased ESG ratings help Moody’s and S&P maintain credit rating business” (p. 30/31).
ESG credit risks: ESG Factors and Firms’ Credit Risk by Laura Bonacorsi, Vittoria Cerasi, Paola Galfrascoli, and Matteo Manera as of Dec. 19th, 2022 (#56): “… ESG factors help explaining the probability of default: when including the ESG factors in a OLS model in order to explain credit risk, together with the traditional accounting variables, they contribute to improve the fit of the model by reducing the mean squared errors. Our main findings suggest that companies with a moderate, rather than large, proportion of revenues related to carbon emissions or to green building have a higher credit risk, implying that an effort in reducing pollution or energy requirements is costly. On the contrary, hiring more skilled workers reduces credit risk, as it is associated to a greater company’s productivity. Interestingly, we provide evidence of a positive externality from environmental friendly locations, since companies located in regions where carbon regulation is stricter exhibit a lower credit risk. Also companies located in regions with better data protection show a lower credit risk” (p. 16).
CSR versus inflation: Inflation, the Corporate Greed Narrative, and the Value of Corporate Social Responsibility by Ana Mao de Ferro and Stefano Ramelli as of Dec. 28th, 222 (#23): “Our results, based on the cross-sectional reactions of US stocks to inflation over the period 2018-2022, indicate that after months of higher inflation, equity investors reward firms with stronger social capital, as captured by their corporate social responsibility (“We find that in months following higher inflation, stocks of higher-CSR firms perform significantly better than stocks of lower-CSR firms” p. 1, 2). The effect holds using different measures of inflation, stock returns, and CSR scores” (p. 20/21).
Bank climate risks: Climate Risks in the U.S. Banking Sector: Evidence from Operational Losses and Extreme Storms by Allen Berger, Filippo Curti, Nika Lazaryan , Atanas Mihov, and Raluca Roman as of Dec. 11th, 2022 (#138): “…. climate risks from extreme storms are a significant source of operational losses at banking organizations. Exposure to extreme storms increases BHC (Sö: bank holding companies) losses from fraud committed by outsiders, failures to meet obligations to clients and improper business practices, damage to BHCs’ physical assets, and business disruption. We show that storms not only increase the frequency of operational loss events on average, but they tend to increase the incidence of severe tail losses that have been associated with financial stability concerns. Major storms have disproportionate, non-linear positive impact on operational losses. Lastly, we find evidence that banking organizations “learn” from exposure to past disasters to mitigate future operational losses” (p. 31).
Bank climate risks (2): Climate Risk, Population Migration, and Banks’ Lending and Deposit-Taking Activities by Mary Brooke Billings, Stephen G. Ryan and Han Yan as of Oct. 18th, 2022: (#69): “… using forward-looking measures of climate risk at the U.S. county level, we provide evidence that banks’ non-agency residential mortgage and small business lending as well as their branch openings and deposit-taking have exposed banks to increasing climate risk of three specific types (hurricanes, water stress, and wildfires) over time. …. Given the increasing frequency and severity of climate-related natural disasters, our results raise concerns about potential negative consequences for migrating households, for the banks and insurers that provide households with financial services, and for the financial system and society were banks and insurers to fail” (abstract).
Bank climate risks (3): Systemic Climate Risk by Tristan Jourde and Quentin Moreau as of Dec. 23rd, 2022 (#128): “… we develop a framework for analyzing systemic climate risks based on environmental and stock market data. We then apply our approach to a sample of Europe’s largest financial institutions. We find that many financial institutions are positively and significantly exposed to transition risk, in particular life insurers and real estate investment trusts. Moreover, we reveal that the exposure to transition risk has increased continuously since 2015, mainly for banks, life, and non-life insurance companies. Finally, our article shows that transition climate risk can exacerbate tail dependence among financial institutions, which is a key aspect of systemic risk. By contrast, we do not find evidence of such contagion effects in the case of physical climate risk. Besides, our results show that climate risk exposure is lower for financial institutions committed to environmental risk management and for those providing long-term incentives to board members. We also highlight that financial institutions with cleaner investment and lending portfolios tend to be less exposed to transition risks (p. 33).
Greenwashing profits: Green Bond Pricing and Greenwashing under Asymmetric Information by Yun Gao and Jochen M. Schmittmann as of Jan.11th, 2023 (#41): “We find that a greenium exists when there is asymmetric information between bond issuers and bond buyers with respect to issuers’ type, transition risks stemming from carbon pricing, and costly greenwashing. The impact of carbon pricing on the greenium and greenwashing depends on the speed with which carbon pricing is introduced – a swift but gradual implementation generates a small greenium and a low level of greenwashing, while a delayed and therefore large carbon pricing has an ambiguous effect on the greenium and greenwashing“ (p. 32).
Improving good ESG: Are Firms’ Disclosed Diversity Targets Credible by Wei Cai, Yue Chen and Li Yang as of Dec. 23rd, 2022 (#56):“… we examine whether firms that publicly disclose diversity targets truly increase their diversity levels after the target disclosure. Exploiting a novel dataset of detailed firm employee records, we find that firms that disclosed a diversity target have indeed improved their diversity, but the diversity level already increased substantially prior to the target disclosure. …. We show that numerical, forward-looking, and rank-and-file employee-targeted goals are more credible than others. We also find that firms that are historically more compliant, with greater institutional pressure, and with greater innovation demand tend to disclose more credible goals, suggesting the importance of examining firms’ incentives rather than the act of disclosure itself” (abstract). My comment: I try to invest in already very sustainable companies (see Artikel 9 Fonds: Sind 50% Turnover ok? – Responsible Investment Research Blog (prof-soehnholz.com) and hope that they intrinsically become even better but I also try to engage with them (see Engagement test (Blogposting #300) – Responsible Investment Research Blog (prof-soehnholz.com)
ESG misreporting: Misreporting of Mandatory ESG Disclosures: Evidence from Gender Pay Gap Information by McKenna Baileya , Stephen Glaeserb , James D. Omartiana , Aneesh Raghunandan as of Oct. 7th, 2022 (#326): “We examine misreporting of mandated gender pay gap disclosures in the UK. We find that approximately one out of twenty employers reports mathematically impossible gender statistics, consistent with widespread misreporting—intentional or otherwise. … We find a negative correlation between financial audit quality and misreporting, but no evidence that CSR audits constrain misreporting. … our results suggest that firms are willing and able to misreport gender pay gap information” (p. 31). My comment: Pay gap merits more attention, see Pay Gap, ESG-Boni und Engagement: Radikale Änderungen erforderlich – Responsible Investment Research Blog (prof-soehnholz.com). Therefore one of my shareholder engagement activities focuses on pay gap.
Irresponsibility consequences: Remedial Actions After Corporate Social Irresponsibility by Wei Cai, Aneesh Raghunandan, Shivaram Rajgopal, and Wenxin Wang as of Dec. 28th, 2022 (#71): “We find that firms do view the reputational damage resulted from ESG-related violations as material enough to take subsequent prosocial actions to restore stakeholders’ trust. Such actions are more likely to be socially-focused and targeted at either consumers or employees, especially in firms with higher board or employee diversity. … we do not find an increase in investment into direct environmental remediation after an environmental violation, although firms that do take such steps enjoy a lower rate of future environmental violations. … it is only indirect social actions that appear to be associated with a lower rate of future social violations – raising questions about the extent to which the types of stakeholders harmed in the initial scandals ultimately enjoy improved treatment by the firm. Finally, we find no evidence that the stock market reacts to reputation-building actions taken in the wake of an environmental or social scandal, relative to actions taken before the violation or with respect to actions taken by a control sample” (p. 25).
Voting and engagement research: Bank climate risks
Illegal engagement? Market Soundings Rules: The challenges and opportunities for board-shareholder engagement by Jennifer Payne as of Dec. 23rd, 2022 (#11): The potential value of effective board-shareholder dialogue for companies, shareholders and participants in the market more generally is well understood. … This paper examines the restrictions placed on such a dialogue by the EU market abuse regime and the solution offered by the market soundings rules for one particular category of board-shareholder engagement. … It is argued that the market soundings regime as currently constructed maps poorly onto a broader vision of board-shareholder dialogue, but that this is unlikely to be unduly problematic for the reasons explored in this paper” (abstract).
Engagement advice: The Contingent Role of Conflict: Deliberative Interaction and Disagreement in Shareholder Engagement by Irene Beccarini, Daniel Beunza, Fabrizio Ferraro, and Andreas Hoepner as of Feb. 10th, 2022: “We find that while deliberative interaction does not help advance the engagement process, it positively moderates the effect of disagreement in the solution-development stage. By contrast, in the solution-implementation stage, deliberative interaction amplifies the negative effect of disagreement, thus hindering progress in the engagement. Our paper contributes to shareholder engagement, deliberation theory and interactionist organization theory by establishing that engagement effectiveness is an interactional achievement, shaped by both deliberation and disagreement“ (abstract).
Low ESG costs? Trade, Voting, and ESG Policies: Theory and Evidence by John Duffy, Daniel Friedman, Jean Paul Rabanal, and Olga A. Rud as of Jan. 13th, 2023 (#86): “We model the interaction between ESG policy proposals, shareholder trading and voting under different sets of preferences, and then test the predictions of our model. In one environment, investor preferences regarding the policy are highly polarized while in another they are dispersed. We find that (i) low policy costs favor policy adoption, (ii) intermediate costs lead to a lower rate of policy adoption under dispersed preferences than under polarized preferences, and (iii) share prices are greater than equilibrium predictions when the policy is adopted. This suggests that the cost to shareholders of adopting ESG policies may be less than anticipated (abstract).
Traditional investment research
Yale, Norway etc: The ‘Investor Identity’: The Ultimate Driver of Returns by Ashby Monk and Dane Rook as of Jan. 17th, 2023 (#581): “What is the most important driver of long-term investment returns? … We argue an investor’s organizational capabilities determine what asset classes are investable and how investors can invest in them. This paper thus conceptualizes an investor’s set of organizational capabilities as its identity. While some have referred to this concept as a “Model” (e.g., Yale Model, Canadian Model, or Norwegian Model), the term „identity“ avoids confusion associated with the numerous other models already at work in the investment business. Accordingly, an investor’s identity is akin to a sort-of “‘kitchen” in that it refers to the specific manner in which an investor “cooks up” its risk-adjusted net returns. Identity thus reflects the true foundations of long-term performance: namely, how an investor organizes its capabilities to allocate assets and implement portfolio strategies” (abstract).
Consultant alpha? Investment Consultants in Private Equity by Jose Vicente Martinez and Yiming Qian as of Jan. 20th, 2023 (#26): “We find that consultants operating in private equity differ significantly in terms of size, specialization, and number of PE managers they work with. Asset owners that share search consultants tend to choose the same private equity funds and managers. Consultants’ size, private equity specialization, and involvement in fund management do not seem to be related to asset owner performance. The consultant trait that seems to be most associated with asset owner performance is the size of the PE manager list their clients draw from. Asset owners advised by consultants that rely on a narrow list of PE managers do better than asset owners advised by consultants that work with a larger list of managers. Among asset owners that share a consultant, it is asset owners that give more business to the consultant (i.e., those with the largest PE mandates) that end up with better investments, something that cannot be explained by mandate size alone or by any other asset owner or consultant attribute” (p. 27)
Skinny returns? Got skin in the game? Investor reaction to managers’ signaling of private investments in mutual funds by Dominik Scheld and Oscar Anselm Stolper as of Jan. 4th, 2023 (#19): “—“Skin in the game”—money managers’ private investments in the funds they run—helps aligning potentially conflicted interests of investors and managers. Prior research acknowledges this benefit but remains silent about how investors are supposed to learn if fund managers have skin in the game. … Analyzing ~16,000 shareholder letters of U.S. mutual funds, we first show that fund managers’ disclosure of private investment leads to excess fund inflows up to two weeks after the letter is sent out. Second, outflows are significantly less pronounced following poor performance. Third, the impact of skin in the game communication on fund flows limits to retail shareholders” (abstract). My comment: I have significant skin in the game regarding my fund
Fund flow effects: Mortality, Mutual Fund Flows, and Asset Prices by Alok Kumar, Ville Rantala, and Claudio Rizzi as of Dec. 27th, 2022 (#20): “… elderly people liquidate their mutual fund holdings regularly. … Periods with high mortality rates are associated with more positive net mutual fund flows and these effects are stronger among high dividend yield and high bond allocation funds. We also find that high mortality exposure stocks consistently earn abnormal returns during abnormal mortality months” (p. 28/29).
Fintech research
Useful machines: Machine Learning Methods in Finance: Recent Applications and Prospects by Daniel Hoang and Kevin Wiegratz as of Dec. 13th, 2022 (#527): “First, we established that different types of ML solve different problems than traditional linear regression with OLS. While the properties of OLS are beneficial for explanation problems, supervised ML is the superior method for prediction problems. … In the second part of this paper, we developed the following taxonomy of ML applications in finance: 1) construction of superior and novel measures, 2) reduction of prediction error in economic prediction problems, and 3) extension of the existing econometric toolset. … In the final part, we provided indications of the future prospects of ML applications in finance by analyzing the ML papers published in major finance journals. … Our results suggest that ML may become even more widespread in finance research in the coming years. They also indicate a particularly large potential of applying ML to unconventional data to construct superior and novel measures of topics related to the field of corporate finance and governance. The fields of behavioral and household finance may also offer a mostly untapped potential for ML in future research“ (p. 47).
Hybrid robos: Algorithm Aversion: Theory and Evidence from Robo-Advice by Cynthia Pagliaro, Tarun Ramadorai, Alberto G. Rossi, Stephen Utkus, and Ansgar Walther as of Dec. 24th, 2022 (#64): “We study algorithm aversion using a model of robo-advising adoption. … We pair this structural model with empirical work on unique data from a large US hybrid robo-advisor. In the robo-advisor we study, as with other such hybrid services, the algorithm manages the investment portfolio, while the human advisor interacts with investors to help them understand what the algorithm does and provides auxiliary advice on issues such as estate planning. A key feature of this setting is that the assignment of investors to advisors follows mechanical rules driven by workload balancing imperatives rather than any assessment of advisor type. This means that once the current “load” of a given advisor is accounted for, the assignment of new clients to this advisor is orthogonal to the historical client retention of the advisor (a useful proxy for advisor type). … We find that this measure of advisor type predicts the future retention rate of clients that are assigned to them, which can be mapped to both the learning channel and the ongoing disutility channel in the model“ (p. 35/36).