Triangulating ESG Ratings and US Bank Systemic Risk

The results on whether banks with higher ESG ratings exhibit lower systemic risk is mixed and dependent on how the banking risk is measured and which provider of the ESG rating data is used. This study reexamines this question by triangulating the ESG ratings published by both the London Stock Exchange Group (LSEG), formerly known as Refinitiv, and the MSCI, formerly known as Morgan Stanley Capital International, and a battery of market and idiosyncratic risk indices captured by the cost of capital, Merton’s (1974) distance-to-default and expected default frequencies, and levered and unlevered equity betas. Applying instrumental variable approaches to a panel data of US banks from 2016 to 2023, the results depend on the risk modeling regimes and vary across the ESG data providers. There is, however, a strong and persistent presence of a nonlinear relationship governing the endogenous behavior of the ESG ratings and bank systemic risk. The risk reducing effect of higher ESG ratings is mainly observed for banks with relatively higher cost of capital (riskier banks) while the opposite is true for banks with relatively lower cost of capital. Further, within this environment, higher ESG ratings from the MSCI data are associated with higher idiosyncratic risks captured by the Merton’s (1974) distance-to-default. Overall, the results support the conjecture that higher ESG investment may not always be aligned with creating value or reducing risk. The results have important implications for both regulators and institutional investors who rely on ESG ratings in assessing a banks resilience and systemic risk.