Recently, the European Banking Authority (EBA) has pressured banks to consider the risks associated with climate change and inequality within their capital buffers. This unprecedented measure pushes financial institutions to incorporate environmental and social risks into the core of the banking industry, paving the way to sustainable finance.
The EBA has set a three-year timeline to introduce necessary changes, and banks must adapt to this evolving landscape in a forward-looking manner.
Within the EU prudential framework for banks, banks must maintain regulatory capital in line with the risk profile of their assets. The impending changes will primarily enhance the inclusion of these risks in Pillar 1 of the framework, a minimum requirement for all banks to fulfil. This change addresses the growing threat to financial stability emanating from ESG factors.
The focus has until now been on the individual bank risk, known as Pillar 2, largely due to the scarcity of adequate data and methodologies for addressing sector-wide ESG risks. However, the landscape is shifting towards a more comprehensive inclusion of ESG risks within Pillar 1, implying extensive capital requirements to be in place.
Nevertheless, it’s important to acknowledge that not all stakeholders agree on this transition. Major banks, such as BNP Paribas, have voiced their opposition to the decision to increase banks’ capital requirements as it would hamper their ability to finance the transition of their clients.
Regardless of whether bank loans will be under strain or models for estimating the repercussions of climate change, environmental degradation, and inequality fall short of the precision of conventional risk management tools, one thing remains certain. This transformation will have a profound impact on traditional risk categories, such as credit, market, and operational risks, as well as on the industries. It will also undermine greenwashing, where organizations issue misrepresented sustainability statements to improve their standing in the eyes of credit assessors.
The transition towards a carbon-neutral economy is happening rapidly, which makes it easier to induce significant losses for banks already exposed to high-risk sectors. Accordingly, banks must implement updated regulatory frameworks throughout their value chains. The conventional risk factors concern the impacts on banks themselves. However, with ESG risks in place, risk management must consider new perspectives – not only the effect ESG risks have on banks, but also the potential impact of stakeholders on banks, and similarly, the risks to which the bank is exposing its stakeholders and the environment due to its business activities.
In this regard, physical ESG risks come into play in conventional risk types – extreme weather conditions can lead to credit defaults, and changes in market sentiment can result in impairments. The coverage of climate damages can affect savings, and outsourced services may no longer be viable. Therefore, the integration of ESG risks not only accounts for risks associated with conventional factors but also carries far-reaching implications, including reputational damage, regulatory scrutiny, and legal liabilities.
In this sense, the EBA’s report comes at a crucial time for the financial sector. There is currently no dedicated regulatory risk-weighting treatment for a C&E risk. However, targeted enhancements presented in the report can catalyse a more accurate identification of these risks where they exist, thereby shaping bank lending. The counterparty’s risk profile and creditworthiness may drive the transactions away from the carbon-intensive sectors. Regulators have, in various ways, broadened the scope of events and features of the investments that could expose the bank to losses, and in a two-pronged manner, it can be instrumental in contributing to a successful economic transition.
Indeed, the transition to a low-carbon economy is drawing a lot more attention as a climate-related financial stability risk, leading banks to take excessive risks when they fail to identify transition risks in their capital requirement calculations. Higher capital requirements can lead to removing certain climate exposures from bank balance sheets altogether when they discourage banks from making particular loans. This mechanism can bolster financial stability by affecting credit allocation and ensuring sufficient loss-absorbing capacity for the loans banks choose to continue making.
However, a notable absence in the regulatory framework that EBA does not currently support is the introduction of a “green supporting factor” or “brown penalizing factor” that could decrease or increase capital requirements accordingly with environmentally sustainable or harmful assets. Considering the capital requirement as the price of making a loan, changes in capital requirements lead to the usual income and substitution effects.
The income effect follows that banks can provide fewer loans in total if the capital requirement for carbon-intensive loans increases. Essentially, the income effect comes into the picture in making a difference between clean and dirty assets. Although raising capital requirements for risky assets has the advantage of not sacrificing the prudential goals, clean lending may be crowded out if some of the bank’s marginal loans are clean, which are inevitably cut back on. Therefore, it is in line with the banks’ grievances, and in light of these concerns, a more targeted approach might be necessary to address these challenges effectively.
The EBA’s efforts to integrate ESG risks into the heart of banking regulations represent a critical step toward fostering a more sustainable and responsible financial sector. However, the industry, regulators, and financial institutions must collaborate to ensure a smooth transition and a balanced approach to managing these risks. This approach can safeguard financial stability while contributing to a greener and more equitable future for all.
This article originally appeared in the opinion section of the website RAPPLER.