A recently published EBA report sets out comprehensive proposal on the inclusion of environmental, social, and governance (ESG) factors and ESG risks in the regulatory and supervisory framework for credit institutions and investment firms. The report provides institutions with common definitions of ESG risks and their transmission channels and identifies evaluation methods that are needed for effective risk management. EBA recommends integrating ESG risks into business strategies, governance, risk management, and supervision in a timely manner. The report provides direction on future supervisory expectations, setting the foundations for future EBA guidelines on this topic. Later this year, EBA plans to publish Pillar 3 disclosure requirements on ESG risks, including transition and physical risks.
With respect to risk management aspects, the report notes that ESG risks materialize through the traditional categories of financial risks such as credit risk, market risk, operational and reputational risks, and liquidity and funding risks. EBA has identified three different approaches for the assessment of ESG risks: portfolio alignment method, risk framework method (including scenario analysis), and exposure method. EBA does not prescribe the use of a particular approach and sees merit in the application of a combination of approaches. The report assesses potential inclusion of ESG risks in Pillar 2 framework by providing common definitions of ESG risks, elaborating on the arrangements, processes, mechanisms, and strategies to be implemented by credit institutions and investment firms to identify, assess, and manage ESG risks. It recommends:
- Embedding material ESG risks in the risk appetite framework
- Exploring ways to include ESG risks in the supervisory review and evaluation performed (SREP) by competent authorities of institutions under the scope of the the Capital Requirements Directive (CRD)
- Managing ESG risks as drivers of financial risks, in a manner consistent with the risk appetite, and as reflected in both the Internal Capital Adequacy Assessment Process/Internal Liquidity Adequacy Assessment Process (ICAAP/ILAAP) frameworks
- Developing stress testing methodologies and practices to better understand institutions’ vulnerabilities related to ESG risks and to evaluate the potential impact, driven by transition and physical risks, on financial and prudential soundness
- Identifying the existing gaps in terms of data and methodologies and take remedial action
- Setting out appropriate policies for considering ESG risks into the assessment of the financial robustness of counterparties
- Developing risk monitoring metrics at exposure, counterparty, and portfolio levels
- Developing methodologies to test the resilience to ESG risks
With respect to governance, EBA recommends that institutions integrate ESG risks into governance structures, establishing clear working procedures and responsibilities for business lines, internal control functions, and the relevant committee(s) and management body. This should cover the management body and its "tone from the top," allocation of tasks and responsibilities related to ESG risks as drivers of financial risk categories in the decision making process, adequate internal capabilities and arrangements for an effective management of ESG risks, and remuneration policies that are aligned with the institution’s long-term interests, business strategy, and objectives. With respect to business strategies, EBA recommends that the impact of ESG risks should be appropriately considered to ensure the resilience of business models over the short-, medium- and long-term horizons. EBA recommends that institutions achieve this through ESG considerations when setting business strategies, in particular by extending the time horizon for strategic planning to at least 10 years, at least qualitatively, and by testing their resilience to different scenarios. EBA also recommends setting, disclosing and implementing, ESG risk-related strategic objectives and/or limits, including related key performance indicators, in accordance with the institution’s risk appetite. EBA recommends engaging with borrowers, investee companies, and other stakeholders and assessing the potential need to develop sustainable products or to adjust features of existing products, as a way to contribute to, and ensure, alignment with strategic objectives and/or limits.
The report proposes a phase-in approach, starting with the inclusion of climate-related and environmental factors and risks into the supervisory business model and internal governance analysis, while encouraging institutions and supervisors to build up data and tools to develop quantification approaches to increase the scope of the supervisory analysis to other elements. This report should be considered in conjunction with EBA and ESAs disclosure publications under CRR, the Taxonomy Regulation, and the Sustainable Finance Disclosure Regulation (SFDR), which provide key metrics to support strategies and risk management. The report is based on the feedback received to the EBA discussion paper on the management and supervision of ESG risks for credit institutions and investment firms.
Keywords: Europe, EU, Banking, Securities, ESG, Climate Change Risk, Investment Firms, Pillar 2, Basel, Governance, Credit Risk, Market Risk, Liquidity Risk, SREP, SFDR, Taxonomy Regulation, Pillar 3, Disclosures, CRD, IFD, Stress Testing, Regulatory Capital, EBA
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