How environmental risks could be included in the prudential framework
On May 2nd EBA launched a discussion paper on their view on how and whether environmental risks may or may not be incorporated in the Pillar 1 prudential framework for credit institutions. This is a long-awaited paper and a possible next step in working more hands-on with quantification of environmental risks.
EBA has mainly evaluated environmental risk including physical and transition risks since social factors are more difficult to identify. Furthermore, less quantitative analysis on social risk are yet available. EBA wants a risk-based approach and the prudential requirements to reflect the underlying risks. Empirical evidence should be underlying in any changes in risk-weights. EBA therefore prefers enhancement within the existing Pillar 1 framework rather than any added supporting or penalizing factors.
The main challenges for including environmental risks are:
- lack of relevant, high-quality and granular data,
- a lack of a common, standardized and complete classification system of what really is environmental friendly that is not binary,
- challenges in use of ESG scores as they have varying scope and quality, and
- the nature of environmental risk and the mismatch between time horizon of financial framework and the long-term horizon over which climate related risk are likely to fully materialise.
With the concluding remarks being:
- The prudential regulation should remain risk based and evidence based and based on objective and observable values
- It is preferred to include environmental risk drivers when possible into existing framework, for example internal models. Where this is not possible some targeted amendments, enhancements or clarifications can be made
- Emphasis on collection of environmental risk related data
- Increase forward-looking methodologies to cover environmental risks if not included in historical data
The framework already allows the inclusion of environmental risk as risk drivers included in internal models and credit ratings. EBA encourages the use of these mechanisms in the Pillar 1 framework, although methods to appropriately capture environmental risks need to be further developed to represent the forward-looking and non-linear nature of environmental risks.
Even if environmental risks are included in risk drivers, the Pillar 1 framework will not fully cover idiosyncratic aspects, these should still be addressed through the Pillar 2 risk assessment.
It is clear in the discussion paper that EBA does not support penalizing or supportive factors. The factors such as the SME supporting and the infrastructure supporting factors are clearly factors implemented politically by the EU commission. In the end it is the EU commission who decides the final framework. It is possible that the commission will override EBA’s opinion on ESG factors and implement penalizing or supporting factors for environmental risks. This can in turn lead to a risk of double counting the risks if also environmental risks are included as risk drivers.
As EBA rather wants to include environmental risk as risk drivers in models this will complicate the banks development of risk models. There is a Catch-22 style situation here as internal models should be based on proven and traceable risk data (i.e historical data) but environmental risks will increase in the future, hence historical data is of little value. Involving forward-looking expert driven aspects into historical data driven models will be a delicate task for risk model developers.
”Integration of environmental risk into risk models will require close co-operation between risk model developers and ESG experts”Patrik Scheele
FCG sees an advantage in including environmental risks as much as possible already to be prepared. In the Banking Package 2021, the Commission communicated that they will in the upcoming review of the CRR/CRD propose binding requirements for the integration of ESG risks. This is to ensure that ESG factors are consistently included in risk management systems of banks and the integration and management of ESG factors will be part of the Supervisory Review and Evaluation Process (SREP).
The first step for banks is to start collecting data on environmental factors, both as possible risk drivers and outcomes that are due to environmental aspects. Data such as geographical location of collateral, emission factors for companies, ESG ratings etc. have to be collected and stored immediately to enable better future models including environmental risk factors.
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