1.  EBA’s questions related to the integration of ESG risk in the prudential framework (may 2022)

1.1.   Context

ESG risks represent, both in their physical and transitional dimensions, new risk factors that aggravate existing risks and need to be considered in capital requirements.

The question is therefore what is the best approach to integrate ESG risks into Pillar 1, avoiding any double counting with the existing, and with the appropriate degree of prudence given the fact that ESG risks will lead to higher and potentially more extreme losses than in the past.

1.2.   The ABE approach

The aim is therefore to assess:

  • Whether the current prudential framework already allows for environmental risk factors to be addressed in a satisfactory manner.
  • Whether there is a need for specific prudential treatment of ESG-sensitive exposures.
  • Whether it is appropriate to use forward-looking methodologies given the forward-looking nature of ESG risks.
  • Whether it is appropriate to introduce “green” support factors and “brown” penalty factors into the methodology for calculating RWAs.
  • Whether it is appropriate to require a general increase in the minimum level of capital requirement given the fact that ESG are going to amplify the existing risk level in the coming years.
  • If it is relevant to consider that ESG risks leading to a deterioration of the risk profile of the portfolio (rating…) will naturally lead, without any change in the minimum regulatory level of capital:
    • Either an increase in the amount of capital of banks owning these brown assets in their portfolio.
    • Or an internal reallocation of capital to the greener sectors within each institution to keep the level of internal capital stable.

1.3.   The treatment of social risks deferred to a second stage due to its complexity and correlation with environmental risks

This EBA analysis focuses on environmental impacts. The analysis related to social impacts will be considered in the next steps. One reason for this is that social impacts are linked to environmental risks. Hence the relevance of starting with environmental risks.

  • Continued deterioration of environmental conditions implies increased social risks, when physical events affect populations, exacerbate migration and social and political unrest, or when technological or regulatory changes dealing with environmental risks impact on labour markets in (non-green) industries.
  • Social risks can also be driven by changes in policy and market sentiment related to social transformation towards a more equitable society, with respect to labour rights or human rights more broadly. These social risks may affect institutions’ counterparties and lead to associated financial risks.

2.  The framework of the EBA analysis

2.1.   A risk-based analysis of the EBA

The analysis adopts a risk-based approach to ensure that prudential requirements reflect the underlying risks and support the resilience of institutions to these risks.

  • Prudential requirements should reflect the risk profiles of exposures and should not be used for other policy purposes.
  • Other policy instruments outside the prudential framework have a more important role to play in the transition to a sustainable economy and will have an impact on risks in the financial sector.

2.2.   Risks covered

The risks covered by EBA analysis are:

  • Credit risk.
  • Market risk.
  • Operational risk.
  • Concentration risk.

These risks cover the different elements of the prudential framework and how they interact with environmental risks.

The EBA proposal details the adjustments that could be made to take account of ESG risk

3.  The conclusions of the EBA analysis

Although it contains some key messages, this EBA proposal is exploratory in nature and does not draw any definitive conclusions.

3.1.   Targeted and specific changes to the methodology for calculating RWAs instead of introducing “green” support or “brown” penalty factors

EBA’s analysis shows that the Pillar 1 framework already includes mechanisms to include new types of risk factors such as those related to environmental risks.

  • These include internal models, external credit ratings and valuations of collateral and financial instruments.
  • Targeted improvements or clarifications in the framework are being explored to explicitly address environmental risks.

Initial analysis indicates that targeted changes to existing prudential requirements will address ESG risks more accurately than “green” support or “brown” penalty factors for RWAs, given the various challenges associated with their design and implementation.


3.2.   Parallel consideration of ESG risk in Pillar 2 for risks not covered by Pillar 1

Under Pillar 2, competent authorities are already assessing additional risks, such as strategic risk, reputational risk or concentration risk, which may be affected by environmental risk factors. Thus, supervisors will include ESG risks as priority areas for supervision in 2022 and for the coming years.

3.3.    Important collection of ESG data is needed to prepare retrospective AND PROSPECTIVE ESG risk assessments

The prudential framework has always been based on retrospective risk assessments. This does not fit well with the forward-looking nature of environmental risks. Banks will therefore need to focus on collecting data on environmental risks and ensure that risk management tools and practices explicitly take environmental risks into account. This will help to prepare forward-looking analyses by overcoming the challenges of data availability that make it difficult to robustly assess ESG risks. This evolution in assessment methodology can be accommodated within the adaptive nature of the current supervisory framework.

4.  References