Introduction

In May 2022, the European Banking Authority (EBA) published a Discussion Paper  with the aim of evaluating whether the current prudential framework adequately covers new risks, such as environmental risk, or whether they should be subjected to a dedicated treatment. Following a consultation window, the EBA published in early October 2023 a follow-up report on the role of environmental and social risks in the prudential framework, integrating feedback from the financial industry and the findings of the High-Level Expert Group on Sustainable Finance and the European Systemic Risk Board (ESRB)2. 

The new EBA report aims to assess the feasibility and suitability of possible clarifications and targeted enhancements to the prudential framework and proposes a series of short and medium-to-long term recommendations for the financial industry participants - institutions, competent authorities, legislators, and external credit agencies. 

In this article, we analyze the EBA recommendations, classifying required actions according to their complexity and time-horizon. We further highlight key short-term actions that should be taken by supervisory authorities and institutions over the next three years. Finally, we outline key principles confirmed in the EBA report regarding liquidity framework, large exposures framework and adjustment factors.  

Some immediate actions required while awaiting further reassessment

Acknowledging that further evidence is required to establish a clear link between environmental and social factors and traditional financial risk categories, the EBA did not engage in extensive changes to the prudential framework, particularly with regard to Pillar 1 requirements. Indeed, most of the recommendations consist of future medium-to-long term reassessment of potential changes, once data has been collected and analyzed as part of the various reporting and disclosure requirements currently coming into force. 

Some short-term actions are nevertheless required to be taken over the next three years in the context of implementation of CRR3 and CRD63, most of which are already anticipated by financial institutions. We analyze these in Figure 1 below, according to their complexity, impact and time-horizon. 

Figure 1. EBA recommendations according to their complexity/impact and time horizon 

Actions required by supervisory authorities:

• Clarification of certain aspects of the regulatory framework, in particular with regard to the credit risk internal model and the inclusion of environmental and social risks in the risk differentiation step, the risk quantification (through, for example, margin of conservativism, downturn component, calibration segments) and in the rating application (e.g. via the use of human judgement and overrides) – (CR-IRB-1). 
  
  

Actions required by financial institutions include:

• Stress testing: On the credit risk side, institutions using internal ratings-based (IRB) approach are required to consider environmental (both physical and transition) and social risk scenarios in their credit risk stress testing programmes (CR-IRB-6). On the market risk side, institutions using internal model approaches (IMA) for some of their trading desks should explicitly consider environmental risks as part of their stress testing programmes (this aspect will be scrutinized as per the revised EBA draft regulatory technical standard (RTS) on the assessment methodology under which competent authorities verify an institution’s compliance with the IMA) - (MR-2).
  
• Categorization of operational risk: Institutions will be required to identify whether environmental and social factors constitute triggers of operational risk losses in addition to the existing operational risk taxonomy (under review as part of the CRR3 mandate) - (OR-1). 
  
• Collateral valuation: Adjustments should be made if the market value of the collateral does not reflect the relevant risks linked to environmental factors that could affect the sustainability of the property’s market value. Adjustments should account for physical and transition climate related risks as well as other environmental risks and should cover the valuation lifecycle (origination, re-valuation and monitoring) - (CR-COL-1).
  

Figure 2. Summary of EBA recommendations

Strong decisions to make no alterations in key areas  

In addition to the short-term actions, the EBA proposes strong principles that were largely pushed forward by the industry during the consultation period. As it stands and at least for the time being, there should be no alteration to: 

• Liquidity framework - as LCR and NSFR appear to already have the adequate framework to account for environmental risks.
  
• Large exposure framework - as the current framework is not appropriate for capturing environmental and social factors related to concentration risks. In the short term, environmental related concentration risk metrics could be considered first through enhanced disclosure requirements complementing existing Pillar 3 disclosures on ESG risks and through enhanced monitoring and supervisory actions as part of the Pillar 2 framework (CONC-3).
  
• Adjustment factors (such as supporting/penalizing factors) - as an acknowledgement of the challenges adjustment factors face. From a risk-based perspective, EBA judges that environmental risk drivers should be addressed through targeted amendments to the current prudential framework rather than dedicated actions.

In the long term, the EBA is open to macro-prudential measures (sectoral SyRB) addressing the systemic component of ESG risks - via the CRD6 proposal. 

Conclusion

The EBA’s follow-up report on the role of environmental and social risks in the prudential framework comes as no surprise. Potential measures on Pilar 1 cannot be thoroughly considered without collecting sufficient data on the impact of ESG drivers and the way they interoperate with traditional risks, which will become gradually possible via Pillar 3 data collection and other disclosure requirements. Institutions’ short-term actions mainly revolve around Pilar 2 and the integration of ESG risks into stress tests.
In addition, there is limited visibility into the time horizons through which medium-to-long-term recommendations will be tangibly addressed, and - more importantly - what the associated binding features will entail.

In the meantime, financial institutions should actively address the following:

• To ensure continuity of regulatory climate stress testing (e.g. Prudential Regulation Authority, EBA), reinforce stress testing capacities to integrate various ESG risk drivers and define multiple scenarios to cover a wide range of possibilities.
  
• Design a robust environmental data framework and actively work on data collection and data quality as an important prerequisite  for any future potential Pillar 1 evolutions.
  
• Engage in regulatory and market discussions to stay up-to-date with the latest industry developments and begin internal exploratory initiatives with prioritized items (e.g. assessing the relevance of additional risk drivers for credit risk differentiation, defining a methodology for calibrating overrides) to accelerate the learning curve and prepare the organization for future regulatory change. 
  

Capco has a strong and varied track record of supporting clients with their change programs, spanning a wide range of system and process implementations. We have developed a unique integration approach for ESG risks which includes integrating ESG risks into risk management processes and creating a robust data framework. Contact us to learn more about how we can help your institution on its journey to change, giving you an edge over your competition.

References

¹ https://www.eba.europa.eu/regulation-and-policy/credit-risk/discussion-paper-role-environmental-risk-prudential-framework and https://www.capco.com/en/Intelligence/Capco-Intelligence/Prudential-Treatment-Of-ESG-Risk 
² https://www.eba.europa.eu/eba-recommends-enhancements-pillar-1-framework-capture-environmental-and-social-risks 
³ European Commission’s Capital Requirements Regulation and Capital Requirements Directive, implementing the Basel 3.1 framework as a last key step to fully leverage lessons learned from the global financial crisis https://www.ecb.europa.eu/press/key/date/2023/html/ecb.sp230609~c9ef904931.en.html