2 Jose Manuel Campa

The European Banking Authority’s chairperson highlights how the organisation is underpinning banks’ efforts to address environmental, social and governance risks, and support the transition to a sustainable economy.

The implications of climate change for the global and EU economy, and hence the banking sector, are expected to pose considerable challenges. There is little doubt that they will drive financial risks at many levels and for many years into the future.

Environmental, social and governance (ESG) risk factors impact banks via their core lending and investing activities, affecting the traditional categories of financial risks (such as credit risk and reputational risk) and, as such, there is a clear link to prudential regulation. Reflecting their growing importance, the European Banking Authority (EBA) is working to enhance disclosure, advance risk-measurement practices and update the prudential framework.

In line with the direction given to the EBA by EU legislators, efforts are ongoing to evolve most, if not all, elements in the regulatory toolbox, spanning disclosures, supervision, stress testing and prudential elements. This is being done in collaboration with key stakeholders, both inside the EU and internationally. A sequential approach is being taken with enhanced disclosure requirements and risk management being the first priorities. This is driven by the need for upgraded disclosures by banks on ESG aspects of their balance sheet, risks and strategies, as well as a more robust integration of ESG risks considerations into risk management and governance.

Disclosure obligations

Enhanced disclosures in the financial sector can help promote market discipline. The reduction of information asymmetry related to bank risk profiles and counterparts’ exposures allows stakeholders to make more informed decisions. With the implementation of a well-defined Pillar 3 framework on ESG risks, the EBA aims to support institutions in their disclosure obligations, facilitating stakeholders’ access to meaningful, comparable information on ESG-related risks, and allowing them to compare institutions’ sustainability performance.

In addition, with the definition of key performance indicators, such as the green asset ratio, this should promote institutions’ transparency on how they are mitigating those risks, including information on how they are supporting their counterparties in the climate change adaptation process and in the transition towards a more sustainable economy.

The EBA is following a sequential approach. Initial focus has been on climate change-related risks. This priority is in line with the developments taking place both at the EU level (e.g. EU taxonomy initially covering climate change sustainability objectives), and at international level (e.g. Basel Committee Task Force on Climate-related Risks, and the IFRS Foundation’s establishment of an International Sustainability Standards Board). The first set of Pillar 3 technical standards that the EBA is publishing, however, also includes qualitative disclosures related to the broader scope of ESG risks.

The EBA is fully aware of the need for coordination at EU and international level. To avoid regulatory fragmentation, we have developed our Pillar 3 standards building on other relevant initiatives, such as the Financial Stability Board Task Force on Climate-related Financial Disclosures’ recommendations and the classifications provided by the EU Taxonomy Regulation. However, when assessing the status of institutions’ disclosures, we still observe that there is room for improvement in terms of consistency and comparability.

We have gone one step further. Our ESG Pillar 3 package should help to address these shortcomings at EU level by setting mandatory and consistent disclosure requirements, including granular templates, tables and associated instructions, and at an international level by establishing best practices.

The EBA acknowledges the challenges in terms of data faced by institutions. There is a clear need for both banks, and their customers and counterparts, to invest in ESG data collection to build the foundation needed for risk management and transparency. Banks will have to make use of every channel, including public sources of information, bilateral data collection in the context of the loan origination and monitoring processes, and estimates.

There is a clear need for both banks, and their customers and counterparts, to invest in ESG data collection to build the foundation needed for risk management and transparency

Considering the efforts necessary to meet the Paris Agreement goals and EU sustainability agenda, institutions cannot further delay the collection and disclosure of these data points, not only to update stakeholders on the risks posed by climate change, but also for their risk-management purposes. We trust that all our work, including our Pillar 3 framework, will push banks in the right direction.

Assessing risks

Closely intertwined with enhanced disclosures, an active measurement and management of ESG risks is a precondition for a transition towards sustainability. The challenges are well-known, given the shortcomings of historical data and degree of uncertainty stemming from the forward-looking perspective required to measure these risks. Environmental risks will likely mean an increase in the frequency and severity of physical risks.

At the same time, changes in behaviours and future policy actions will no doubt increase transition risks. The development of new tools and methodologies in this context will be key.

Methods for the assessment of ESG risks are evolving rapidly. The EBA has identified three types: the portfolio alignment method, which focuses on how aligned an institution’s portfolio is with global sustainability targets; the risk framework method (including scenario analysis), which focuses on how sustainability-related issues affect the risk profile of an institution’s portfolio and its standard risk indicators; and the exposure method, which focuses on how individual exposures and counterparties perform on ESG factors. These approaches provide insights into the risks faced by institutions.

Going forward, institutions need to expand efforts to enhance their internal risk measurement, modelling and risk management skills. They also need to further embed ESG risks into their business strategies and internal governance arrangements. ESG risks will furthermore be incorporated into supervisory practices, as reflected in the EBA report on ESG risk management and supervision published in June 2021. Concrete guidance will be provided to ensure harmonised supervisory practices.

Climate stress-testing and scenario analyses are also increasingly being used by supervisory authorities. Last year, the EBA published the results of its first pilot exercise on climate risks, mapping banks’ exposures, and shedding light on data and classification challenges confronting banks. The Single Supervisory Mechanism has planned a 2022 climate stress test, and several national regulators have conducted, or are planning to conduct, climate change-oriented stress tests. These exercises all provide insights that will help us as we look to embed climate risk in the EBA EU-wide stress testing framework in the coming years.

The prudential aspect

The EBA has initiated work to assess whether a dedicated prudential treatment of exposures substantially associated with environmental objectives would be justified. We will follow a two-step approach by first developing a discussion paper in early 2022 to receive stakeholders’ feedback before issuing a final report at a later stage.

Our starting point is the need to follow an evidence- and risk-based approach, which is how the prudential framework was conceived. Prudential regulation should remain geared towards ensuring the safety and soundness of institutions and safeguarding financial stability, as opposed to being a tool to incentivise banks to redirect capital. The objective is to evolve prudential regulation to help ensure banks will continue to finance the transition to a more sustainable economy. In this context, it is important to remember that financial sector regulation is but one of the policy tools available. Prudential regulation should not be a substitute for other necessary changes in broader industrial, environmental and economic policies.

This prudential risk-based approach includes as key aspects assessing whether there is evidence of a risk differential or specific risk profile for specific exposures, and whether the peculiarities of environmental risks necessitate amending the existing framework. It should assess the extent that environmental risk factors, as drivers of traditional categories of financial risk, may already be reflected — albeit indirectly — in the current assessments of risk, but will become more prominent going forward. These risks can also have a much longer time horizon compared to the time horizon currently embedded and assumed in the application of the existing prudential regulation.

Potential enhancements to prudential standards should also be considered at the international level and the EBA welcomes the Basel Committee on Banking Supervision’s decision to assess whether climate risks need to be better captured. Ongoing developments under other parts of the regulatory framework should also be considered to help design the most suitable prudential response.

New business prospects

The needed transition towards a more sustainable economy will surely spur new business opportunities. It will, however, also expose financial institutions to risks stemming from this transition. Although some of these risks will only materialise over the medium-to-long term, action is needed now to progressively start implementing the necessary steps. Given the potential of ESG risks to fundamentally change the way EU economies work, a strategic approach must be taken.

The EBA’s actions are designed to support the incorporation of ESG risks considerations by both supervisors and banks, with the aim to safeguard the resilience of the financial sector in the short, medium and long term. This is key to ensure that banks are well-positioned to effectively address ESG risks and support the transition to a sustainable economy.

José Manuel Campa is chairperson of the European Banking Authority.

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