Response to discussion paper on the role of environmental risk in the prudential framework
Go back
As such they will affect leverage ratios. Given the growing physical and transition risks, as a result of inadequate changes in the real economy, the overall capitalization of banks, including their leverage ratio, may need to be increased.
To account for this both the risk weighting of pillar one (SA and IRB) could be increased for the most damaging loans (e.g. new fossil fuel exploration, deforestation) or penalizing factors can be introduced (Chamberlin & Evain, 2021).
There have recently been developed two notions of double materiality (Boissinot et al., 2022). The ‘weak’ double materiality refers to individual company risk or a systemic risk. It is established in the risk approach and the notion that supervisors should protect the financial system from risk stemming from, in this case, environmental causes. The ‘strong’ version of double materiality entails a more transformative approach. It goes beyond just the risk perspective and puts the onus of climate action not just on the private sector, but also the supervisors as guardians of the system. This is also called a ‘proactive’ role of the central banks (Oustry et al., 2020).
We do note however that the concept of double materiality is mentioned in the EBA report, but nowhere is it applied. We consider this a grave shortcoming.
The best approach therefore seems to be to quickly start with adjusting factors targeted at the largest risks, while at the same time start with the more gradual and detailed process of adapting the methodologies used in pillar 1 SA and IRB to become more forward looking over a longer time horizon.
When this latter approach starts delivering results, the adjustment factors may be reduced
Adjustment factors should also be calibrated annually to reflect the risk as good as possible. However, accepting that this will never be perfect.
Q1: In your view, how could exposures associated with social objectives and/or subject to social impacts, which are outside the scope of this DP, be considered in the prudential framework? Please provide available evidence and methodologies which could inform further assessment in that regard.
The social taxonomy is an EU analog to the Green Taxonomy and provides examples of activities that are contrary to the EU stated social goals (Platform on Sustainable Finance, 2022). Depending on the prudential risk connected to the worst performers in this area, extra risk weights could be given.Q2: Do you agree with the EBA’s assessment that liquidity and leverage ratios will not be significantly affected by environmental risks? If not, how should these parts of the framework be included in the analysis?
We do not agree that leverage ratios will not be affected. There is broad consensus, including amongst supervisors (NGFS, ECB), that environmental risks pose material financial risks (NGFS, 2019). Climate stress tests have repeatedly shown that physical and transition risks present a danger to almost all areas of the Eurozone (although unequally) and all sectors in the real economy and finance (Alogoskoufis et al., 2021). As the recent energy crisis in Europe has shown, commodity shocks spread unpredictably across various sectors.As such they will affect leverage ratios. Given the growing physical and transition risks, as a result of inadequate changes in the real economy, the overall capitalization of banks, including their leverage ratio, may need to be increased.
Q3: In your view, are environmental risks likely to be predominantly about reallocation of risk between sectors, or does it imply an increase in overall risk to the system as a whole? What are the implications for optimum levels of bank capital?
Environmental risks will certainly have an effect between sectors. Credit risks differ depending on the exposure to physical and transition risks to which large differences exist between sectors. However, given the still growing overshoot of the use of environmental factors the physical and transition risks currently are still growing. As is well documented in macroeconomic scenarios (Alogoskoufis et al., 2021), this exposes the economy to large and growing losses that will to a large extent end with the financiers, including banks.Q4: Should the ‘double materiality’ concept be incorporated within the prudential framework? If so, how could it be addressed?
It should as in the end it is highly relevant for the prudential objective. Double materiality shows how banks through their lending can increase risks that will end to a large extent on their own balance sheet.To account for this both the risk weighting of pillar one (SA and IRB) could be increased for the most damaging loans (e.g. new fossil fuel exploration, deforestation) or penalizing factors can be introduced (Chamberlin & Evain, 2021).
There have recently been developed two notions of double materiality (Boissinot et al., 2022). The ‘weak’ double materiality refers to individual company risk or a systemic risk. It is established in the risk approach and the notion that supervisors should protect the financial system from risk stemming from, in this case, environmental causes. The ‘strong’ version of double materiality entails a more transformative approach. It goes beyond just the risk perspective and puts the onus of climate action not just on the private sector, but also the supervisors as guardians of the system. This is also called a ‘proactive’ role of the central banks (Oustry et al., 2020).
We do note however that the concept of double materiality is mentioned in the EBA report, but nowhere is it applied. We consider this a grave shortcoming.
Q5: How can availability of meaningful and comparable data be improved? What specific actions are you planning or would you suggest to achieve this improvement?
Voluntary schemes and relying on purely market-based mechanisms might prove ineffective, slow, and promote greenwashing in the (financial) markets (Smoleńska & van ’t Klooster, 2022). Governments and regulators ought to mandate disclosures and more consistent data gathering and reporting. They could invest in capacity-building and partner with the private sector to facilitate data provision (van Tilburg et al., 2022). Technological solutions, such as satellite imaging, could be favored to further improve the data coverage.Q6: Do you agree with the risk-based approach adopted by the EBA for assessing the prudential treatment of exposures associated with environmental objectives / subject to environmental impacts? Please provide a rationale for your view.
We do, the EBA should continue relying on the risk-based approach. However, as the effects of climate change are amenable to various tipping points and non-linearities, true future risk might never be accurately calculated. For that reason, supervisors and legislators should base their decision on the so-called precautionary approach (Chenet et al., 2021; Kedward et al., 2020). This approach recognizes that the future states cannot be associated with specific risks, but is in fact unknowable and uncertain. This however should not keep supervisors from acting now, as this will with a large degree of certainty lead to an increase of the overall risk. The precautionary principle mandates supervisors to err on the safe side and act on incomplete information and in a discretionary manner: better roughly right than exactly wrong (Elderson, 2021; Kay & King, 2020). This principle is well recognized in the EU practice. It is defined in the EU Treaty under Article 191 and its use was clarified and reinforced by the European Commission . This gives the EBA a firm legal basis to incorporate and act on this principle. We are therefore disappointed that the precautionary principle or approach is not mentioned once in the EBA report.Q7: What is your view on the appropriate time horizon (s) to be reflected in the Pillar 1 own funds requirements?
Pillar 1 time horizons are too short to accommodate most environmental-related financial risks (Coelho & Restoy, 2022; Demekas & Grippa, 2021; Smoleńska & van ’t Klooster, 2022) and need to be extended to at least 10 years.Q8: Do you have concrete suggestions on how the forwardlooking nature of environmental risks could be reflected across the risk categories in the Pillar 1 framework?
One reason why Pillar 1 is often cited as inadequate for addressing climate risk is its backward-looking methodology. One way to address this setback could be to introduce more forward-looking methodologies in Pillar 1 assessment (Bingler et al., 2020; Bingler & Colesanti Senni, 2020; Raynaud et al., 2020). While many of these methodologies are in their infancy and present a work in progress, their use is necessary for a more accurate vision of individual transition pathways and climate exposures. In spite of their imperfections, they present a first useful step towards a more forward-looking risk assessment. Again, the precautionary principle mandates to act now rather than wait until risks materialize and it is too late to do anything about these.Q9: Have you performed any further studies or are you already using any specific ESG dimensions to differentiate within credit risk? If so, would you be willing to share your results?
Please note that the studies you cite are most if not all backward looking. For assessing environmental risks this is an important shortcoming. Forward looking studies do find large impacts of material risks and hence lead to a different conclusion than the one that EBA draws that “there is still little empirical evidence of a risk differential” for environmentally harmful exposures.Q15: Do you consider that further risk differentiation in the corporate, retail and/or other exposure classes would be justified? Which criteria could be used for that purpose? In particular, would you support risk differentiation based on forward-looking analytical tools?
Yes, specifically large exposures to fossil fuels and other polluters should be taken into account. Finance-Watch in its One-for-One campaign has argued that new fossil fuel explorations should be fully covered by bank’s own equity (Philipponnat, 2020). Furthermore, this modification in risk weighting is not foreign to the BCBS as they have proposed a similar measure to cryptocurrency exposure (BCBS, 2021). Systemic risk buffers could also be used for this purpose, as they are a familiar and well used tool in the countries of the Union (Monnin, 2021). One criterion that could be used to distinguish the performance are the credible transition plans (Evain et al., 2022). These could be cross-referenced with the state of the art forward-looking transition risk tools.Q17: What are your views on the need for revisions to the IRB framework or additional guidance to better capture environmental risks? Which part of the IRB framework is, in your view, the most appropriate to reflect environmental risk drivers?
The IRB framework would need to become more forward looking and increase the time horizon in order to be able to capture environmental risks.Q21: What would in your view be the most appropriate from a prudential perspective: aiming at integrating environmental risks into existing Pillar 1 instruments, or a dedicated adjustment factor for one, several or across exposure classes? Please elaborate.
Given the urgency to address the environmental risks that now largely go unaccounted for, speed is of the essence. An adjustment factor is a simple tool that fits the nature of environmental risks better than an approach that depends on detailed modelling exercises (Haldane, 2012).The best approach therefore seems to be to quickly start with adjusting factors targeted at the largest risks, while at the same time start with the more gradual and detailed process of adapting the methodologies used in pillar 1 SA and IRB to become more forward looking over a longer time horizon.
When this latter approach starts delivering results, the adjustment factors may be reduced
Q22: If you support the introduction of adjustment factors to tackle environmental risks, in your view how can double counting be avoided and how can it be ensured that those adjustment factors remain risk-based over time?
Double counting should be the least of the supervisors worry given the current state of environmental risk management, as evidenced by the two damning progress reports of the ECB with regards to its supervisory expectations. The most recent one stated that “virtually none of the banks disclose all the basic information on climate-related and environmental risk that would align with all of the ECB’s expectations” and that “institutions still scarcely substantiate their climate-related and environmental metrics and targets” (ECB, 2022).Adjustment factors should also be calibrated annually to reflect the risk as good as possible. However, accepting that this will never be perfect.