Paper Title: ESG and Banking Performance in Emerging and Developing Countries: Do Islamic Banks Perform Better?

Author:        Faaza Fakhrunnas, Turalay Kenc and Zhang Hengchao

Publisher:    Journal of Islamic Monetary Economics and Finance, 11(1), 175-198

This paper investigates the effects of Environmental, Social, and Governance (ESG) implementation on banking performance in emerging and developing countries. Applying the Two-step System Generalized Method of Moments (System-GMM) to panel data of 179 banks across 29 countries spanning 2016-2022, the authors claim that ESG implementation significantly enhances overall banking profitability. However, when they assess the implications of ESG on Islamic banks, they find that overall ESG commitment significantly reduces profitability. As for the individual ESG pillar, authors note the profit-enhancing effect of environmental pillar on both Islamic and conventional bank profitability. Some evidence is also uncovered for the significant positive effect of social pillar on conventional bank profitability. Finally, the authors inform no significant influences from governance pillar.

These results highlight the divergent impacts of ESG implementation on Islamic and conventional banks. It is concluded that policymakers should exercise caution in designing and implementing ESG policies, ensuring they are tailored to promote optimal performance across different banking models.

The analysis also reveals significant differences between Islamic and conventional banks regarding the impact of ESG practices on banking performance. Islamic banks are found to be better when implementing environmental pillars. Conversely, taking into account the ESG framework as a whole and implementing it in Islamic banking operations creates an additional cost that lowers the return of Islamic banks.

From the results, the authors arrive at the following two main conclusions: (1) ESG practices are pivotal for banking performance in emerging and developing countries, and (2) Islamic banks possibly face trade-off between commitments to ESG practices and the Shari’ah-compliant framework. Nevertheless, Islamic banks obtain financial benefits when focusing on environmental pillar activities. As for a policy implication at the banking level, banks in emerging and developing countries need to integrate ESG practices into their banking operations. 

The banks’ ESG commitment can be in the form of adopting ESG framework in their banking operation and business strategy, incorporating ESG in credit assessment, and integrating ESG commitment in their banking products. In the case of Islamic banks, incorporating the environmental pillar can be adopted in the form of promoting green financing and integrating environmental risks in the banking operation. At the policy level, the financial authority is required to have an ESG framework to be implemented in the banking industry. 

A step-by-step implementation can be adopted on a voluntary basis, and sufficient incentives can be provided for banks that have ESG commitments. In addition, financial authorities must engage in ESG activities such as issuing green bonds/sukuk and having macro and micro-prudential policies based on the ESG framework. However, in the dual banking system, a tailor-made ESG framework needs to be adopted to recognize the uniqueness of Islamic banks, especially in the presence of the Shariah governance framework.

The tailor-made ESG framework is important to ensure the absence of potential overlap between incorporating ESG and implementing Shari’ah principles. Our study is confined to investigating the impact of ESG implementation on banking performance using profit-based measurement. Future studies probably need to elaborate on risk-based measures of performance while also extending not only ESG and its pillars but also the indicators in each pillar. Thus, the findings of the study can precisely capture the impact of ESG at the level of the indicators on banking performance.

In future researches, the authors must extend time span for the study to study the short run and long run influences. They missed an important control variable interest rate which must have been part of the banking performance model.

There is also a need for more careful analysis to check bi-directional causality. It could be that profitable banks have better leverage to engage in ESG practices which add cost and time. While facing trade-offs and cost, not so well performing banks may not engage in ESG practices more intently. Thus, it is important to check causality in both ways.

It is also important to study the relation through non-parametric tests and contingency tables. Regression based inferential analysis is good to establish statistical association, but the economic significance could also be gauged directly and clearly through descriptive analysis and by use of contingency tables and non-parametric tests.

Furthermore, it is important to distinguish between ESG reporting and ESG performance. The issue of green washing implies that both are not necessarily the same. Talk and announcements are not the same as committed actions and resource allocations which are extra-ordinary.

Furthermore, the trade-offs between ESG and Shari’ah Compliance need to be discussed more clearly. The literature overwhelmingly shows affinity between ESG and Maqasid-e-Shari’ah as complements.

 The authors need to discuss more comprehensively why they expect a trade-off between Shari’ah compliance and ESGs. Trade-offs may exist between ESG components. For instance, the long-run focus on environmental versus short-run disruptive effects on the social component. But the authors had not given this point much consideration.