Policy implications of ESG-moderated credit risk on bank profitability

In this study, I evaluated the ESG-moderated impact of credit risk on bank profitability and then addressed the policy issues that arose. A case study of South Africa was appealing owing to its financial system's prominence in the African emerging markets. Methodologically, I employed the fixed effect model with careful attention to specification necessities. The analysis was based on 10 stock-exchange-listed commercial banks over 18 years (2006 to 2023). While prior research did well to study the respective effects of environmental, social, and governance (ESG) factors and credit risk on bank profitability, its shortcoming was overlooking their mutual impact. That is, how bank performance changes if credit risk is ESG-moderated. Accordingly, past findings could not explain whether ESG adoption in banking practice lessens credit risk, let alone elucidate the advantageous knock-on effects on the financial system. The current paper bridges this knowledge gap, and the results are insightful. First, I confirmed the economic intuition of a positive relationship between ESG factors and bank profitability. Second, the research outcomes concurred with the literature in part that credit risk and bank performance are inversely related, but take a step further to show that the association is nonlinear. Lastly, I discovered that ESG-compliant banks experience reduced credit risk compared to their ESG-indifferent counterparts. This finding has useful spillover effects in the economy through the fractional banking systems. To enhance ESG's effectiveness, decision-makers should strengthen policy initiatives that support ESG reporting standards, integration, international benchmarking, and regulatory harmonization.