Does ESG enhance asset quality and funding cost management in banking diversification?

This study examines the impact of Environmental, Social, and Governance (ESG) practices on asset quality and funding cost management within the global banking sector, focusing on the role of income diversification. Motivated by the increasing importance of sustainability in finance , this research explores how ESG performance influences banks’ loan portfolio quality and funding costs, particularly through a focus on classical interest income from lending activities versus non-traditional non-interest income. Utilizing a dataset of 1,865 banks across both developed and emerging markets from 2005 to 2022, this study employs panel fixed-effect regression models to assess the relationship between ESG integration, income diversification, and financial outcomes. The findings reveal that banks with stronger ESG performance experience enhanced asset quality and reduced funding costs due to a greater reliance on interest income activities. However, over-diversification into non-interest income activities is associated with deteriorating asset quality and increased credit costs. These results have significant implications for financial risk management , regulatory policy, and the development of sustainable banking practices in both mature and developing financial markets. The study provides a foundation for guiding banking sector policies that balance revenue diversification and ESG sustainability, ultimately enhancing banks’ asset quality and funding cost management. • Examine the cross-section of expected returns using a parsimonious model of risk premia, focusing on the impact of Environmental, Social, and Governance (ESG) practices on asset quality and funding cost management, with particular attention to the role of income diversification. • Investigate whether ESG can enhance banks’ asset quality and reduce interest expenses through revenue diversification. • There is a negative relationship between ESG performance and bank non-performing loans, as well as between ESG and banks’ interest costs. • Banks with stronger ESG performance tend to experience improved asset quality and lower funding costs due to a greater reliance on interest income activities. • Over-diversification into non-interest income activities is linked to deteriorating asset quality and increased credit costs. However, ESG practices can mitigate this deterioration.