The EBA recommends enhancements to the Pillar 1 framework to capture environmental and social risks

The European Banking Authority (EBA) today published a Report on the role of environmental and social risks in the prudential framework of credit institutions and investment firms. Taking a risk-based approach, the Report assesses how the current prudential framework captures environmental and social risks. It recommends targeted enhancements to accelerate the integration of environmental and social risks across the Pillar 1. The proposed enhancements aim to support the transition towards a more sustainable economy, while ensuring that the banking sector remains resilient.

Environmental and social risks are changing the risk profile for the banking sector and are expected to become more prominent over time. They affect traditional categories of financial risks, such as credit, market and operational risks. Hence, environmental and social factors may affect both the risks faced by individual institutions and the financial stability of the entire financial system.

The Report recommends risk-based enhancements to the risk categories of the Pillar 1 framework. It also develops considerations on the potential use of macroprudential tools. The Report explains why the EBA does not support the introduction of a green supporting factor or a brown penalising factors at this stage. The use of such adjustment factors presents challenges in terms of design, calibration, and complex interaction with the existing Pillar 1 framework.

Against this background, the EBA puts forward recommendations for short-term actions to be taken over the next three years as part of the implementation of the revised Capital Requirements Regulation and Capital Requirements Directive (CRR3/CRD6).

In particular, the EBA is proposing to:

1. Include environmental risks as part of stress testing programmes under both the internal ratings-based (IRB) and the internal model approaches (IMA) under the Fundamental Review of the Trading Book (FRTB).
2. Encourage inclusion of environmental and social factors as part of external credit assessments by Credit Rating Agencies.
3. Encourage the inclusion of environmental and social factors as part of due diligence requirements and valuation of immovable property collateral.
4. Require institutions to identify whether environmental and social factors constitute triggers of operational risk losses.
5. Progressively develop environment-related concentration risk metrics as part of supervisory reporting.

Taking a medium-to-longer term perspective, the Report also presents possible revisions of the Pillar 1 framework reflecting the growing importance of environmental and social risks. These include:

1. The possible use of scenario analysis to enhance the forward-looking elements of the prudential framework.
2. The role that transition-plans could play in the future as part of the development of further risk-based enhancements to the Pillar 1 framework.
3. Reassessing the appropriateness of revising the IRB supervisory formula and the corresponding standardised approach (SA) for credit risk to better reflect environmental risk elements.
4. The introduction of environment-related concentration risk metrics under the Pillar 1 framework.

Alongside other policy initiatives outside the prudential framework, the EBA will continue to strengthen the integration of environmental and social risks across all pillars of the regulatory framework.

Legal basis and background

The EBA is mandated under Article 501c of Regulation (EU) No 575/2013, i.e. the Capital Requirements Regulation (CRR), and Article 34 of Regulation (EU) 2019/2033, i.e. the Investment Firms Regulation (IFR), to assess whether a dedicated prudential treatment of exposures related to assets, including securitisations, or activities (CRR), and of assets exposed to activities (IFR) associated substantially with environmental and/or social objectives would be justified.

The Report builds on the principles presented in the EBA Discussion Paper on the role of environmental risks in the prudential framework, published in May 2022.