Banks in Europe will need to adjust the risk assessments they conduct of their clients to reflect new ESG requirements enforced by their watchdog.
In a world first, the European Banking Authority is revising the framework that sets industrywide capital requirements for lenders — known as Pillar 1 — to incorporate environmental and social risks. Some of the obligations will be enforced immediately, while others will be rolled out over time and will in some cases lead to new legislation, according to the EBA.
For banks, the regime means they’ll have to review default and loss probabilities, as well as the risk weights that go into determining how much capital they set aside for each client account. The development may have major implications for high-emitting sectors such as oil, gas, cement, steel and mining.
Cracking down on such risks will be “a key area” for banks under the new framework, said Jacob Gyntelberg, director of economic and risk analysis at the EBA. Current rules already allow banks to “take a forward-looking perspective,” and this is “one of the areas where we should be able to move a little bit faster,” he said in an interview.
Global banking and financial stability organizations are all reviewing reporting and capital frameworks, though none has moved as fast as the EU in setting firm requirements. The Basel Committee on Banking Supervision expects to publish a proposed framework for reporting climate-related financial risks before the end of the year that will help guide regulators across jurisdictions.
The EBA is aware that it’s “the first authority publishing specific suggestions on how to practically incorporate E&S risk considerations into the prudential framework,” Gyntelberg said.
The European Banking Federation, an umbrella organization for lender associations across the region, is worried there’s inadequate data to justify imposing Pillar 1 ESG adjustments, rather than so-called Pillar 2 rules, which are specific to individual banks, said Denisa Avermaete, senior adviser at the EBF.
The EBF’s key concern now is that the prudential framework “remain evidence and risk based,” she said. “It is also crucial that once the EBA considers a more comprehensive revision of Pillar 1 or a macroprudential framework, this is done at a global level to ensure a level playing field for EU banks.”
Gyntelberg says that for financial supervisors, “the Pillar 1 capital process is more disciplined. That’s because banks tend to devote “a lot more resources” to complying with Pillar 1, which “makes it easier to follow as a supervisor.”
Banks With Sector Emission Targets
The EBA says ESG-related losses are set to become more correlated, which is “changing the risk profile for the banking sector. The development is expected to become more pronounced over time and has implications for “traditional categories of financial risks, such as credit, market and operational risks,” according to the watchdog.
Its report contains more than five pages of instructions to banks and national supervisors for short and longer-term changes. Banks and their national supervisors will be expected to reassess collateral values and incorporate environmental risks into trading book budgets. That includes internal trading limits and the creation of new products, the EBA said.
Banks and their supervisors will also need to ensure client credit assessments acknowledge that ESG factors are “drivers of credit risk,” the authority said. Internal risk models will need to be adapted, and default probabilities — as well as the likelihood of losses stemming from such events — will need to be adjusted, the EBA said.
Inevitably, such measures will require that the industry dedicate extra resources, and “banks will no doubt be concerned about the cost implications related to data collection and development of models to better reflect the role of E&S factors,” Gyntelberg said.
Some major banks are already trying to adapt.
BNP Paribas SA, the European Union’s biggest bank and the target of a lawsuit by climate activists, has extended restrictions on fossil fuel lending to its capital markets business, meaning it will no longer help arrange deals if the issuer intends to use the proceeds to finance new exploration and production. And this month, the German unit of ING Groep NV said it’s rejecting clients that fail to provide credible emissions-reductions plans.
Such steps follow warnings from institutional investors who are losing patience with banks. They want the gatekeepers of capital to use their clout to impact greenhouse gas emissions by steering cash away from heavy emitters and toward green clients.
Meanwhile, litigation is becoming a growing threat for banks dragging their feet, according to the Network for Greening the Financial System, a group of more than 100 central bankers and regulators formulating recommendations to get through the climate crisis.
In a recent interview, Jean Boissinot, deputy director for financial stability at the French central bank and head of secretariat at NGFS, said “what is clear is that if it stays in a blind spot, there will be a painful wake-up call” for banks.
James Alexander, chief executive of the UK Sustainable Investment and Finance Association (UKSIF), said in an interview last month that many institutional investors are “frustrated” at the pace of progress. And that’s fed “a real appetite for using litigation.”
Lawyers advising the industry warn that a lawsuit doesn’t need to prevail in order for defendants to be hit by the fallout.
There’s a “very clear reputational impact and damage,” Sonali Siriwardena, global head of ESG at Simmons & Simmons, said at a recent UKSIF event. “They might not have success, but they do the damage.”
The requirements unveiled by the EBA last week are just the first in an ongoing series of adjustments to bank rules that will increasingly bring ESG assessments into the industry’s day-to-day operations.
“When it comes to environment-related concentration risk, we have to carry on building metrics,” said Stephane Boivin, acting head of the ESG risks unit at the EBA. But it “will take time, because it has to be risk-based and rely on actual evidence and data.”