Credit fundamentals don’t always tell the full story. Alastair Sewell explains how ESG analysis of a South Korean bank drove an exclusion in our liquidity strategies.
Read this article to understand:
- The key short-term ESG risks liquidity investors need to consider
- Why governance tends to be the key ESG consideration when investing in short-term securities issued by financials
- How the example of a Korean bank illustrates why ESG analysis is a vital part of the risk management toolkit for liquidity investors
Transcript for video Factoring responsibility into liquidity
Responsible investment is an increasingly important consideration for many investors.
When it comes to liquidity funds, investors will often ask, what can a liquidity fund actually do in terms of responsible investment? The answer, more than you might think. Liquidity funds, like other funds, are exposed to businesses, banks in particular – which may be affected by environmental, social or governance risks. The E-S-G risks.
We can improve our risk management by assessing these properly and factoring them into our investment decisions.
Most of our liquidity funds classify as Article eight under the European Sustainable Finance Disclosure Regulation. Article eight funds promote environmental or social characteristics.
We have devoted significant energy to integrating ESG factors into our responsible investment process, supporting our classification under the regulation.
Our responsible investment process for liquidity is multifaceted. We operate a series of baseline exclusions. These allow us to filter out entities with specific ESG risk factors. ESG integration then drives our final selection of approved issuers within the screened universe.
We produce and maintain specific ESG views on the issuers in which we invest, taking into consideration third-party data and ratings and our own proprietary research. As part of our issuer review process, approval is required by both our ESG analysts and our credit analysts to ensure ESG is integrated in our decision making.
We update our assessments as we see new developments and operate a quarterly ESG portfolio review. This means our ESG views remain current and can be reflected effectively in our portfolios.
One recurring question is how to reconcile the short-term investment horizon of liquidity funds with the longer-term time horizon over which ESG developments typically develop. The operating word here is “typical”. E, S or G risks can flare up suddenly and be material to liquidity funds. The prime example of this is governance risks. These can occur in the form of fines or other adverse events at less well governed entities, at any time. Identifying governance risks can therefore be highly material to short-term credit profiles.
More fundamentally, there is an important distinction to make. While liquidity funds can only buy short-term securities, they’ll typically roll maturities, with the result that they can have near continuous ongoing exposure to any given issuer. This means liquidity funds are exposed to long-term developments affecting these issuers.
It also means liquidity funds have an important role to play in engaging with issuers on long-term issues.
We engage actively with invested issuers.
The bottom line: integrating ESG factors into the investment process helps us manage short-term risks.
And while we invest over the short-term, we are nonetheless, long-term stewards of capital.
As long-term stewards, our scale and influence can help us drive positive change.
Investing responsibly is increasingly important for many investors. Regulatory requirements have increased, with the European Union’s Sustainable Finance Disclosure Regulation (SFDR) of particular relevance.
Since 2021, funds have been classified under SFDR Articles 6, 8 or 9, depending on their level of sustainability (with Article 9 funds having sustainability as a core objective). And, since the beginning of 2023, funds, including our liquidity funds, have had to disclose specific details of their responsible investment approach. Going forward, we will need to report on how we perform against the characteristics of our responsible investment process.
These disclosures mark an inflection point. Funds have made great progress in explaining what they do in terms of responsible investment; the focus from now on will be demonstrating what we do.
Investing liquidity responsibly
We implement responsible investments in our liquidity funds, which are classified Article 8 under the SFDR. This means they promote environmental or social characteristics. You can find the regulatory disclosures for our Article 8 liquidity funds, which explain how we implement our responsible investment framework, on our website.1
In our view, the overt consideration of environmental, social and governance (ESG) factors help us manage risk better and contribute to positive change in the broader financial ecosystem. Liquidity funds have short investment horizons. This means we focus primarily on near-term risks facing issuers. Short-term ESG risks are typically shocks to a company and can manifest via controversies brought on by issues like lapses in governance, misconduct or health and safety breaches.
Next frontier for financials
A common refrain around responsible investment is that data paucity or quality is a limiting factor. For financial institutions – the bedrock of liquidity funds’ portfolios – environmental and social data are improving, but gaps remain. Governance information, on the other hand, is not only readily available, but material to the short-term risks of most relevance to liquidity funds.
Nonetheless, there are upcoming developments to be aware of, in particular on environmental activities. Specifically, the next step in SFDR is disclosure of EU taxonomy related activities by financial institutions, due from January 2024. This will provide useful information, potentially allowing liquidity funds to tilt portfolios towards financial institutions with a higher share of taxonomy related activities and away from those with lower shares.
In future, Scope 3 emissions could become an important indicator. For financial institutions, these include emissions generated through their lending activity. Work is underway on this topic, including the European Central Bank’s recent paper on bank lending and fossil fuels and the Bank of England's on climate-related disclosures.2,3 Achieving consistent, high-quality data will be challenging, but represents a significant market opportunity in differentiating financial institutions.
As such, understanding the quality of governance and an ability to manage risks are paramount.
Governance tends to be the key ESG risk for the financials we invest in
That is not to say “E” and “S” factors do not matter. We consider a range of such factors in determining the eligible investible universe for our liquidity funds. However, governance tends to be the key ESG risk for the financials we invest in.
Importantly, we are long-term stewards of our investments. While we will only buy short-dated securities, we can have exposure to a given issuer for a sustained period. This means our actions in directing funding can and do have impacts way beyond the stated maturity of any given security.
Applying governance factors
Governance factors we consider include:
- The presence of sound management structures
- Good employee relations
- Fair staff remuneration
- Compliance with tax regulations
Conversely, companies involved in corruption, tax evasion or other governance scandals (without taking remedial action) will fall foul of our process.
This analysis factors directly into our approved issuer selection for the liquidity funds.
Our responsible investment process in brief
Our responsible investment philosophy is to invest in the transition to a more sustainable future, with a focus on engagement over divestment. We seek to identify and invest in companies that either focus on delivering sustainability solutions or exhibit the highest standards of corporate behaviour, or those that are transitioning and evolving to become more sustainable and responsible.
In summary, we follow these six steps:
- ESG baseline exclusions policy
- Corporate good governance qualitative assessment
- Approved issuer process
- Continual review of fund and issuer ESG performance
- Engagement with held issuers to promote positive sustainable outcomes and support the investment decision-making process.
- Climate engagement escalation programme
There’s a lot of work which goes into this process; please contact us if you want to know more.
Our ESG resources
We have a dedicated responsible investment team, covering all aspects of ESG. Our corporate ESG research team works with our credit analysts in forming sector- and issuer-specific ESG views. The information and analysis resulting from this is available to all portfolio managers as part of the investment process.
We tend to focus on the decomposition of ratings into specific ESG risks
We also use third-party ESG data and ratings. On the latter, we recognise there are limitations, so tend to focus on the decomposition of ratings into specific ESG risks and the associated underlying data in forming our overall ESG views.
Case study: South Korean bank - governance assessment in practice
The bank in question is one of the largest banks in South Korea and frequent issuer in the short-term market. We often have exposure to the bank in our liquidity funds as a result.
However, the bank has faced several governance issues in recent years, including:
- Insider trading: In 2018, the chairman and other executives were accused of insider trading related to a subsidiary's stock sale. The executives were later cleared of the charges, but the incident raised questions about the bank's governance.
- Management structure: The bank’s management structure has been criticised for being too centralised, with too much power concentrated in the hands of a few executives.
- Conflicts of interest: Some of the bank’s executives have been accused of conflicts of interest, such as serving on the boards of companies that do business with the bank.
- Risk management: The bank has also faced criticism for its risk management, particularly in relation to loans to large companies that have experienced financial difficulties.
- Shareholder rights: Some investors have raised concerns about the bank's position towards minority shareholders, including allegations of unfair treatment and lack of transparency.
These issues raised concerns over transparency, accountability and management, and highlighted the need for improved governance structures and practices in South Korea’s banking industry.
The bank’s CEO faced multiple, albeit ultimately dismissed, charges for manipulating recruitment in March 2022. We saw this as an aggravating factor in combination with other aspects of the bank’s governance and decided to lower our internal governance assessment score for the bank. This change meant it was no longer eligible for investment by our liquidity funds. We allowed existing investments to mature naturally and ceased making any new purchases.
Engagement is core to our responsible investment process. While we chose to stop investing in the bank in our liquidity funds, our credit and ESG analysts continued to engage with the bank, both to gather information and to communicate our concerns. During these meetings, we learned the bank was implementing changes to its governance structure. The combination of these changes and resolution of legal proceedings led us to improve our internal governance assessment score. The bank was subsequently re-admitted to our eligible issuer list and the liquidity funds resumed investment.
The bank’s outstanding bonds fell in price during our exclusion period; for example, the May 2023 bond fell from around 103 to around 99, driven by increasing worldwide interest rates. In practical terms, it meant we exited positions when yields were lower, and re-entered at higher yields once governance had improved.
Second, five-year credit-default swaps in the bank started and ended the period at approximately the same level (around 34 basis points (bps)). However, during the exclusion period, the CDS spiked to a high of around 58bps. While the CDS price has no direct impact on our liquidity portfolios, it provides an indication of market sensitivity towards the issuer, which can affect pricing across security types.
The exclusion action therefore reduced portfolio risk by avoiding the volatility observed in the CDS price and provided good timing for entering and exiting our exposure.
There are several important implications from this case:
- It shows it is possible to differentiate issuers based on governance characteristics. In this case, our broader governance concerns were crystallised in an event.
- Engagement and exclusion are not mutually exclusive. We continued to engage while the bank was excluded.
- ESG considerations can have a direct impact on portfolio risk. In this case, our ESG view contributed to us reducing exposure and avoiding negative price and volatility effects during the exclusion period.
Figure 1: Case timeline
Source: Aviva Investors, May 2023
Going beyond credit fundamentals
Governance has always been important to credit. Simply put, stronger governance provides more protections to debt investors. This point is specifically enshrined in the regulation covering liquidity funds (the money market fund (MMF) regulation):2
- Article 19: The manager of an MMF shall establish, implement and consistently apply a prudent internal credit quality assessment procedure, including (Article 22) qualitative indicators.
Qualitative indicators are specified in delegated acts to the MMF regulation, and include a specific provision on governance as part of the framework for assessing the creditworthiness of a given issuer:3
- Article 5 (e): an analysis of governance risk relating to the issuer, including frauds, conduct fines, litigation, financial restatements, exceptional items, management turnover, borrower concentration and audit quality.
Our responsible investment framework goes beyond the governance requirements of the regulation. The “acid test” in our view involves differentiating between governance developments that are credit relevant and those that have could have a broader effect on portfolio risk.
No rating agency changed any rating or outlook on the example bank during this period
The South Korean bank case is a good example of this test. Rating agencies consider governance as part of their credit risk assessments of issuers. As the developments at the bank were public, this information was known to rating agencies. However, no rating agency changed any rating or outlook on the bank during this period.
The fact our view changed shows that our process goes beyond credit fundamentals to take a broader view of governance as part of a holistic portfolio risk assessment. Our minimum external credit quality for the purposes of our eligible issuer list is F1/P-1/A-1. From an external perspective, the bank in question was eligible for investment throughout the period. Its credit quality was stable. We chose differently because of additional ESG risks. By acting on these, we avoided adverse market developments. That’s risk management in practice.
Key takeaways
- Responsible investment is a priority for many investors, and subject to increasing regulation.
- A robust responsible investment process demands resources, skill and commitment.
- As our case study shows, our actions were influenced by a responsible investment view that objectively differed from the fundamental credit view of rating agencies. This demonstrates our process goes above and beyond minimum requirements and makes a tangible contribution to our risk management and portfolio decision-making.
- Moving forward, there will be greater focus on doing what we say. We did exactly as we said in this case, going beyond regulatory requirements to implement our own responsible investment view.
