The European Banking Authority (EBA) is planning to revise capital requirement frameworks mandating banks to include environmental and social risks,
In a report, EBA chairman Jose Manuel Campa stated that the EBA has identified some immediate solutions to minimum requirements or Pillar 1.
Other changes will be introduced gradually, he said, and a few will necessitate new legislation as outlined in the EBA’s recently published report.
For banks, the regime means they will have to review default and loss probabilities, as well as the risk weights that go into determining how much capital they set aside for each client account.
Moreover, banks and regulators must revaluate collateral values, incorporate environmental risks in trading book risk limits, internal trading boundaries, and new product development.
They will also have to ensure external credit assessments account for environmental and social factors as credit risk drivers.
The development may have major implications for high-emitting sectors such as oil, gas, cement, steel and mining.
Up to this point, regulators mainly focused on bank disclosure and individual bank-specific risks or Pillar 2 because they lacked enough data and methods to assess environmental, social and governance (ESG) risks across the sector.
The objective is to address the growing concerns among regulators regarding threats to financial stability posed by ESG factors such as climate change and inequality.
The proposals have not been welcomed by everyone. In response to the EBA’s consultation last year, the European Banking Federation (EBF) disagreed with using Pillar 1 to tackle climate risks, contending that capital assessments should accommodate variations in bank balance sheets.
The main worry, according to the EBF, is the lack of adequate data to justify imposing Pillar 1 ESG adjustments, rather than so-called Pillar 2 rules, which are specific to individual banks.
The EBA has rejected an industry call for lower capital requirements to encourage lending to companies that invest in technologies to address climate change, or penalties for exposures to heavy polluters.
It said such a factor could mask risks, leaving banks without the necessary buffers and compromising “the reliability of capital requirements as indicators of risk,” the authority said.
Campa said the new ESG requirements are “very concrete.” However, they won’t have the same impact on capital ratios as the so-called Basel III rules that followed the financial crisis of 2008, he said.
For now, the new ESG buffer rules aren’t “going to lead to a significant, discrete increase in the short term,” Campa said.
That’s partly because models for estimating the fallout of climate change, environmental degradation and inequality are in their infancy, compared with conventional risk management tools that have been built on historical data.
“There are a lot of areas that we need to understand better,” Campa said. “One thing that is interesting that we capture in this report — and it’s important for people to realize — is that as you think about regulation, we need to think differently about the methods that we have to assess this risk.”
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