Environmental risk assessment in financial institutions

Abstract

Have the environmental risk assessment policies and procedures instituted by banks been successful in promoting the welfare of the environment? Have these policies and procedures succeeded in protecting banks from environment related liability? This thesis examines the impact of environmental risk management processes on the lending practices of banks. It also evaluates the success of these processes in achieving the goals for which they were implemented. In underwriting environmental risk, financial institutions are primarily concerned with the degree to which they are exposed to liability for the cleanup of a collateralized property. Through this thesis research, it was found that bank lending practices do not address issues of environmental sustainability, such as product and building design, and air and land quality. These issues of environmental sustainability are indirect factors that are not given much weight by the banks since banks are concerned about the direct risk factor of liability. There are three reasons why the lending policies of banks are narrowly focused on direct liability risks: (1) the creation of unlimited liability for banks by federal legislation (2) the focus of banking regulations on this liability and (3) the short time frame that banks use in their credit models. The findings of this research show that banks still have significant sources of direct environmental risk. The regulatory system that has defined the environmental risk factors for banks has proven itself inefficient. Based on the cases presented in this thesis, banks have not decreased the contamination of the properties held in the portfolios. The banks have responded to this regulatory environment by insulating themselves against liability risk. The regulatory environment has created a dead-weight loss to the banking system, where the banks incur costs for addressing environmental liability risk, yet there is little increased benefit to society. A question that arises in reviewing these findings is: if banks are afraid to lend to environmentally contaminated properties because of liability concerns, why haven't other players stepped in fill this void by charging more to the borrowers of these potentially contaminated sites? Other areas of the economy have segmented in reaction to this type of market failure. For example, there is a lending market that targets homeowners who need credit but who have poor credit histories. Why does the market for high-risk environmental loans remain undifferentiated? While the limits of this study preclude offering a comprehensive answer to this question, the initial findings of this study do provide insight and guidelines for further research.