The European Banking Authority (EBA) recently published a report that recommends enhancements to the Pillar 1 framework, under the prudential rules, to capture environmental and social risks. EBA is recommending this approach in favor of the introduction of a green supporting factor or a brown penalizing factors, as EBA believes that the use of such adjustment factors presents challenges in terms of design, calibration, and complex interaction with the existing Pillar 1 framework. This report builds on the principles presented in the May 2022 EBA discussion paper on the role of environmental risks in the prudential framework.
In the report, EBA is recommending the following key short-term actions (over the next three years) as part of the implementation of the revised Capital Requirements Regulation and Capital Requirements Directive (CRR3/CRD6):
- Include environmental risks as part of stress testing program under both the internal ratings-based and the internal model approaches under the Fundamental Review of the Trading Book (FRTB)
- Encourage inclusion of environmental and social factors as part of external credit assessments by Credit Rating Agencies
- Encourage inclusion of environmental and social factors as part of due diligence requirements and valuation of immovable property collateral
- Require institutions to identify whether environmental and social factors constitute triggers of operational risk losses
- Progressively develop environment-related concentration risk metrics as part of supervisory reporting
EBA also sets out the possibility of the following medium- to long-term actions:
- The possible use of scenario analysis to enhance the forward-looking elements of the prudential framework
- Future adjustments based on the role that transition-plans could play as part of the development of further risk-based enhancements to the Pillar 1 framework
- Reassessment of the appropriateness of revising the internal ratings-based supervisory formula and the corresponding standardized approach for credit risk to better reflect environmental risk elements
- Introduction of environment-related concentration risk metrics under the Pillar 1 framework
EBA will further consider how scenario analysis could be used to enhance the forward-looking elements of the prudential framework. The report also identifies regulatory reporting as one of those areas where further work is needed to enable the collection of relevant and reliable information on environmental risks and their impact on financial losses of institutions. In this context, EBA plans to propose amendments to its supervisory reporting and disclosures framework, including the progressive development of environment-related concentration risk metrics.
Keywords: EU, Banking, ESG, Environmental Risk, Social Risk, Basel, Pillar 1, Regulatory Capital, Stress Testing, Concentration Risk, CRR3, CRD6, IFR, EBA
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