Prof. Turalay Kenc

Professor, INCEIF, Malaysia

Banks are no longer confined to their traditional roles of financial intermediation and risk management. Increasingly, they are being called upon to fulfill broader mandates encompassing sustainability, ethical finance, and social responsibility. These expectations—driven by policymakers, regulators, and advocates of the green economy—are reshaping the strategic and operational frameworks within which banks operate.

Yet, these evolving mandates are being superimposed onto institutional architectures that were not originally designed to support them. Without parallel reforms in regulatory frameworks, funding models, and competitive dynamics, the push toward ethical banking may inadvertently undermine the resilience and efficiency banks are expected to maintain. This policy brief argues for a recalibrated institutional approach—one that aligns banking architecture with the realities of contemporary expectations and competitive pressures.

Key Issues

1.    Structural Constraints on Banking Performance

In many market economies, banks tend to exhibit lower risk-adjusted returns—such as Sharpe ratios—compared to non-financial firms. This pattern does not necessarily signal inefficiency but reflects the impact of prudential regulatory frameworks that tightly constrain risk-taking and compress profitability. For instance, in Malaysia, return on assets has remained around 1.2%, with net interest margins under persistent pressure. Similar dynamics are observed in other jurisdictions, such as the Gulf Cooperation Council (GCC) countries and several Southeast Asian economies, where capital adequacy requirements, liquidity rules, and supervisory expectations emphasize financial stability over profitability.

While such regulatory conservatism enhances systemic resilience, it also imposes trade-offs. Banks operating under these constraints often face limited strategic flexibility, especially when responding to new mandates such as environmental, social, and governance (ESG) integration, financial inclusion, and sustainable development goals. The mismatch between static regulatory frameworks and dynamic policy expectations creates structural frictions that hinder innovation and limit the scalability of ethical or purpose-driven banking models.

2.    Intensifying Competition from Open Banking and Digital Finance

The competitive landscape is undergoing rapid transformation. Open banking frameworks and the proliferation of nonbank digital finance providers—such as fintechs and platform-based lenders—are eroding the traditional dominance of banks. These new entrants typically operate with greater agility and fewer regulatory constraints, offering data-driven, customer-centric services that outpace conventional banking offerings.

This regulatory asymmetry puts banks at a disadvantage. They are compelled to innovate within legacy compliance regimes, while competing against more flexible, less-regulated players. This dual pressure—modernization under constraint—complicates banks’ efforts to advance ethical and sustainability goals within their current operational boundaries.

3.    Asymmetric Integration of Ethical Principles

Although banks have made notable progress in embedding ESG and ethical goals on the asset side—via sustainable lending, green bonds, and impact investing—their liability structures remain largely conventional. Deposits, interbank borrowings, and wholesale funding continue to follow traditional risk-return dynamics, with minimal incorporation of ethical or risk-sharing instruments such as Sukuk, social bonds, or participatory finance mechanisms.

This disconnect between ethically aligned assets and conventional liabilities introduces a structural asymmetry that impairs the coherence and sustainability of ethical banking models. It hampers banks’ ability to internalize ESG principles across the balance sheet, thereby exposing them to reputational and strategic risks. Moreover, the absence of innovation in liability instruments restricts the scalability of ethical finance by impeding efforts to match long-term, purpose-driven investments with commensurately aligned funding sources.

Regulatory frameworks and market conventions often exacerbate this problem. Capital adequacy requirements, liquidity rules, and accounting standards tend to favor standardized instruments over bespoke ethical products—thus discouraging innovation. Without deliberate regulatory support and targeted market development, this structural misalignment is likely to persist.

The urgency for reform is heightened by the pace of digitalization. Traditional models of bank intermediation are increasingly under threat. Decentralized finance (DeFi) offers an alternative characterized by greater transparency and flexibility. However, it also raises critical questions: can DeFi replicate the expertise, judgment, and trust traditionally associated with banks?

4.    Expanding Mandates Without Institutional Reform

Banks are not typical commercial enterprises. They are stewards of systemic trust, charged with protecting depositors, maintaining financial stability, and allocating capital prudently. Banks play a pivotal role in transforming savings into productive credit by performing liquidity, maturity, and credit risk transformation—bridging short-term depositor funds with long-term lending needs while managing associated risks.

Imposing additional ethical and social responsibilities—without rethinking the institutional and regulatory architecture that governs them—risks undermining their core functions. Ethical banking cannot be achieved through mission statements alone; it demands structural alignment and systemic coherence.

Policy Recommendations

1.    Reform Funding Structures to Support Ethical Mandates

Promote the development and uptake of ethical and risk-sharing instruments on the liability side of bank balance sheets. Aligning funding mechanisms with ESG objectives will address structural asymmetry and support sustainability goals.

2. Tailor Regulatory Frameworks to Enable Responsible Innovation

Regulators should adopt adaptive frameworks that allow for responsible innovation in ESG and sustainability domains, without compromising prudential oversight.

3. Prioritize Institutional Resilience Over Pure Profitability

Policymakers must acknowledge that banking efficiency extends beyond profitability. It encompasses risk prudence, regulatory compliance, and systemic trust. Evaluating ethical banking models through this broader lens is critical.

4. Foster Synergies Between Traditional and Digital Finance

As DeFi and open banking models mature, stakeholders should explore hybrid frameworks that combine the strengths of both—leveraging the flexibility of digital finance while retaining the reliability and judgment of traditional banking institutions.

Conclusion

The transition toward sustainability and ethical banking is both timely and necessary. However, its success depends on more than rhetoric or superficial commitments. Without substantive institutional and regulatory reform, the expectations imposed on banks may exceed their structural capacities—threatening financial stability and the long-term viability of ethical finance.