EU banks will be required to include ESG risks in capital requirement overhaul

October 23, 2023|Written by Moriah Costa|European Banking Authority

In a global first, Europe’s main banking regulator is overhauling its capital requirement framework and requiring banks to include environmental and social risks in their reserves.

The European Banking Authority (EBA) has already identified short-term fixes to minimum requirements that will be implemented right away, while other changes will be phased in over time. The latest requirements are just the beginning of what is meant to be a continuous reworking of European banking capital frameworks amid the increasing threat of climate change.

Under the new changes, banks and national regulators will be expected to incorporate environmental risks into trading book risks, make sure collateral values incorporate physical and transition risks, adapt models to calculate risks arising from incorporating ESG factors, and ensure that credit assessment includes ESG considerations as “drivers of credit risk”.

In addition, the EBA is proposing to include environmental risk in its stress testing program and develop risk metrics for supervisory reporting. Over the long term, it plans to use scenario analysis to enhance forward-looking aspects of the prudential framework and introduce environmental concentration risk metrics.

Bank lobby groups have been opposed to capital requirement changes. Last year, BNP Paribas, the EU’s largest bank, said such changes would impede its ability to finance the transition. BNP has been hit by lawsuits in France over fossil fuel financing and alleged human rights abuses.

Incorporating climate risk issues under Pillar 1 of the Basel framework is a great step, as measures under the other capital pillars do not “thwart the risk of financial institutions being destabilised by the impact of climate change”, said Vincent Vandeloise, senior research and advocacy officer at Finance Watch.

“The role of Pillar 1 to guarantee consistency of risk treatment at the level of the whole banking system is of fundamental importance from the climate-risk perspective,” he said.

However, Vandeloise said it is disappointing that the EBA will use historical loss data despite acknowledging that historical data-based approaches do not work with climate risk. Instead, the EBA should focus on forward-looking data, he said.

“Past data cannot help us to properly analyse climate-related financial risks. They are by nature forward-looking, unprecedented and increasing over time as they remain largely unmitigated. As things stand there is a high chance of underestimating these risks,” he said.

While the EBA report also looks at stress tests, there are limitations, he said. His comments echo concerns from other academics, such as a landmark report that found current climate change scenarios are underestimating potential risk.

Banks are likely to face losses as the world transitions to a net-zero economy, but that loss can be mitigated with a quicker transition in the EU, a recent report from the European Central Bank found.

This page was last updated October 24, 2023

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