How important are ESG ratings for financial institutions? Evidence from corporate leverage ratios across Europe

This study aims to examine the relationship between corporate leverage and environmental, social and governance (ESG) ratings, and how this relationship is affected by a country's level of financial development. Financial development is examined through its two main components: the development of financial institutions and the development of financial markets. To address our research questions, we analyse a sample of European listed companies observed from 2007 to 2022 and employ various model specifications, including the use of instrumental variables to mitigate endogeneity concerns. Our main findings indicate a negative relationship between leverage and ESG ratings in countries with low levels of financial institution development. However, this negative relationship weakens and even turn positive in countries with more robust financial institutions. The index measuring access to financial institutions is the most important component of financial development in explaining the observed relationships. Moreveor, the positive effect of financial institutions on the relationship between ESG ratings and leverage is strengthened when ESG ratings are higher and in industries where fewer companies have ESG ratings. Overall, our findings contribute to the existing literature suggesting that corporate ESG ratings have a different signalling value in the credit assessment of financial institutions than in that of financial market investors. This discrepancy may be due to the more effective monitoring processes implemented by financial institutions, raising important implications, particularly for policymakers, banks and investors.