Response to discussion Paper on management and supervision of ESG risks for credit institutions and investment firms (EBA/DP/2020/03)

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7. Do the specificities of investment firms compared to credit institutions justify the elaboration of different definitions, or are the proposed definitions included in chapter 4 also applicable to them (in particular the perspective of counterparties)? Please elaborate on the potential specificities of investment firms in relation to ESG risks and on how these specificities, if any, could be reflected in this paper.

Please see answer to Question 21.

14. Specifically for investment firms, do you apply other methodological approaches, or are the approaches described in this chapter applicable also for investment firms?

Please see answer to Question 21.

21. Specifically for investment firms, what are the most relevant characteristics or particularities of business strategies, internal governance and risk management that should be taken into account for the management of the ESG risks? Please provide specific suggestions how could these be reflected.

1.- No specific comments are made regarding the EBA’s general structure of risk identification, measurement and risk management measures, which, as the document itself specifies, are basically aimed at credit institutions.
This is without prejudice to that indicated below with regard to investment firms.
2.- The Working Group (WG) is not aware of any experiences in the application of specific methodologies for measuring ESG risk, (i) due to the initial stage we are at in this matter, (ii) because there are investment firms that due to their activity profile will rely to a large extent on the information available on counterparties or customers, (iii) because counterparty risk is limited only to certain activities, and (iv) because other specific risks, such as suitability assessment risk, have different profiles, as mentioned below.
3.- The WG share the criteria set out by the EBA in section 6.5, specifically with regard to the fact that what is proposed in the Discussion Paper does not apply to investment firms, or only partially to activities on own account. WG is also of the opinion that investment firms should incorporate, depending on their type of activities and profile, ESG risk considerations.
In particular, an analysis of how these risks should be included in the investment firm’s risk management policy should be performed, including an analysis of the implications for the competitiveness of each entity if ESG criteria are not adequately incorporated.
4.- ESG risk analysis at an investment firm must follow the same method as prudential risk analysis. This type of risk should be included in the analysis of prudential risks, such as credit, counterparty, market and operational risk.
In the case of investment firms, this prudential risk has more pronounced operational risk profiles, depending on each of the activities that these entities may carry out.
5.- Review by type of activity, in terms of services to investor customers:
- Intermediation: Intermediation activities –whether fixed income, equities or derivatives– generally do not generate ESG risks since the risks are taken against the market and the market’s clearing and settlement systems. In those cases where positions are taken on own account simply for the purpose of executing customer instructions, if the customer were to face any problems due to ESG factors, this would be counterparty non-compliance that would be handled by the investment firm (e.g. through transactions with opposite signs in the market).

Beyond that, ESG risks are not considered to be material with regard to the intermediation business.

- Dealing on own account. In this type of activity, there could conceptually be a risk in the event that a counterparty suffers ESG risks and this implies a deterioration in their financial position or business situation. There are several possible situations:
o Trading on own account in the market. The counterparty risk is actually that of the market and its clearing and settlement systems, so ESG risk would not be relevant in this case.
o Bilateral transactions with a counterparty. Here, in turn, there are two possible scenarios:
 Counterparty that is a customer. Special attention should be given to each contractual structure and guarantee provisions, which currently is already done, but also taking into account ESG elements.
 Counterparty with other financial institutions. This is the same as the previous case, except that, since financial institutions are required to have an ESG risk management policy, this will be an aspect to be included in the risk assessment of these transactions.
o Own portfolio. ESG risks can affect the valuation of an investment firm’s own portfolio.
o Other transactions on own account, such as underwriting the placement of issues. Its implications are discussed below.

- Asset management. Asset management poses no direct ESG risk for an investment firm. The result of the investments, whether positive or negative, and therefore of the ESG risk that they entail, will be apparent in the assets of the customer, not in those of the investment firm.

However, in the assessment of the customer’s suitability, to determine the proper investment profile for the portfolio management activity, and for the investment of the portfolio following the customer’s ESG preferences, there is conceptually a new risk, the appropriate assessment by the investment firm of the preferences expressed by customers in this regard.

This is a scenario in which ESG risk is not a counterparty risk, but rather a risk of liability to the customer, if any.

- Investment advice. Similar to the case of portfolio management, ESG risks are considered in this case as a facet of the risk of assessing the suitability of the advice in accordance with the ESG preferences expressed by the customer. Therefore, this is another scenario in which ESG risk is not a counterparty risk, but rather a risk of liability to the customer.

- Custody. In relation to the custody activity, this activity is not considered to have any specificities in relation to ESG risks. These risks do not appear to have a significant impact on this activity or on the risks it poses to investment firms or their customers. In selecting sub-custody service providers and their risk profile, the ESG risk profile of the financial institution should merely be included as an additional element.

- Clearing and settlement. ESG risk considerations with regard to these post-trading activities, insofar as they involve activities in which money and/or securities must be received from customers and delivered to third parties, should incorporate ESG elements in the risk analysis carried out for each customer, as long as they are relevant for the assessment of their capacity to meet their obligations and their counterparty risk.
For issuer services (corporate):
- Investment advice. The advisory activities in this area include the analysis of the market situation, the assessment and design of the transaction, etc., as well as the role as the Lead Entity, where appropriate. There is a specific liability regimen for entities acting as Lead Entities for a securities placement, with regards to the content of the prospectus. Thus, the ESG risks of the issuer should be taken into account in drafting the prospectus in order to ensure that its content is correct and complete.

The rest of advisory activities to issuers do not show specific ESG risks.

- Placement. Placement activities must be carried out within a very specific regulated framework in which, on the one hand, the customer must be made award of prospectus drawn up by the issuer and, on the other, the conduct of business rules with the customer must be followed. This regulatory framework does not indicate that the investment firm can assume specific ESG risks.

- Underwriting. As this is an activity in which the investment firm assumes risk against its own balance sheet on its own account, the ESG risk elements of the issuer should be included in the risk assessment that the investment firm carries out at that time.

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