The Panama Papers appear to be yet another scandal in the banking sector. The relevance for us as investors is that if banks are found to have engaged in illegal tax evasion practices, their reputation will be damaged and they can face big fines. This affects profitability and debt repayment capacity.
Setting up tax avoidance structures in itself is not illegal. The key question is if and to what extent banks have knowingly contributed to hiding assets of their wealth management clients from the tax authorities – tax evasion - or even facilitated money laundering.
If banks are fined, this can lead to higher capital requirements, as they are included in the determination of risk weighted assets; more stringent compliance demands; or even rating downgrades. In our credit investment process, we include material ESG factors in our analysis. They are one of the five elements at which we look, in addition to company strategy, company position, financial profile and company structure.
The material ESG factors for banks are risk management, corporate governance, business ethics, responsible finance and sustainable investment integration. For business ethics, we look at issues such as banks’ exposure to ethical issues like fraud, money laundering and codes of conduct. Sustainability integration refers to, for example, the integration of ESG factors in lending decisions and financial inclusion. Finally, responsible finance relates issues such as the charging of excessive fees, predatory lending and undisclosed product risks.
We look at the scores our colleagues at RobecoSAM award companies on these aspects, scores of other sustainability research houses, and we do our own analysis. If a bank ranks weak on, for example, RobecoSAM’s code of conduct criteria, this functions as a warning signal. Illustrative is that RobecoSAM recently added a number of questions on banks’ risk culture to its annual Corporate Sustainability Assessment survey.
In the investment process of our global equity strategies, each investment case includes an assessment of how the most material ESG issues affect a company’s competitive position and valuation. Having identified the material factors, our SI research analysts at RobecoSAM assess the impact of these factors. Our Global Equity analysts then quantifies this impact to adjust the value drivers of – in this case – a bank, comprising growth (loan and deposit growth, fee and other income), efficiency (expenses) and financial drivers (capital adequacy and leverage).
ESG factors that are material for our investments in banking stocks are risk management, corporate governance, human capital (which is important in reducing costs but also in retaining the most talented people) and controversial issues. The Panama papers are an example of the latter. Potential controversial issues are related to internal compliance, codes of conduct, anti-crime policies and money laundering. A bank that carefully manages these issues will have a greater social license to operate in various countries and will be less vulnerable to reputational damage.
In addition to analyzing the risks and opportunities of the status quo, we also actively aim to improve companies’ tax policies. We are currently preparing an engagement on tax accountability at several companies in which we invest. We will start this engagement in the third quarter of this year.
‘Besides analyzing current risks, we actively aim to improve companies’ tax accountability’
Even if a company does not resort to illegal activities, aggressive tax policies in which multinational listed companies use legal structures to optimize their tax burden are increasingly viewed as a risk. For example, tax inversion - a company consistently pays taxes in other regimes than the ones in which its operational activities take place – can lead to reputational risks and negatively affect the relationship with relevant stakeholders. International tax harmonization could be a solution in this respect, but also improved transparency, for example by publishing tax policies and country by country reports, could allow companies to offer investors and other stakeholders a better insight into the risks associated with their tax policies.
Although we consistently look at material ESG factors related to tax policies and structures, it is as yet unclear what consequences the Panama papers will have for banks. We monitor all banks with wealth management activities extra carefully, but do not see any reason to change our portfolios at this point.