Response to discussion paper on the role of environmental risk in the prudential framework

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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.

We agree with EBA’s risk-based approach for the consideration of environmental risk in the prudential framework and believe that the consideration of social risks should follow this risk-based approach as well. Thus, we see exposures associated with social objectives and/or subject to social impacts currently out of scope for further Pillar I measures. Currently, there are no clear definitions agreed (EU social taxonomy, which is not a risk measurement tool) and there is a lack of (historical) data and methodology to measure social risk.
We acknowledge social risk as a topic for future integration in terms of a holistic ESG target picture and of course, many initiatives to support social targets run within banks but at first, the integration of climate / environmental risks into the prudential framework should be in focus.

Furthermore, exposures associated with social objectives and/or subject to social impacts should be considered in unison with the environmental impacts. Especially in the case of promotional banks, these two types of risks often affect one another. One example would be social housing corporations; the housing they provide could be subject to certain environmental risks but at the same time they fulfill an essential role in society by providing housing to certain groups. Trying to mitigate the environmental risks by, for example, including these risks in the loan pricing is not in the best interest of the social aspect.
This interaction requires both aspects to be dealt with simultaneously through a similar mechanism in the prudential framework.

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?

Yes, we agree that liquidity will not be significantly affected by environmental risks.

Nevertheless, the impact has to be regularly assessed within the overall environmental risk materiality assessment as foreseen by ECB Guide on climate-related and environmental risks under Pillar II.

We also fully agree that leverage ratios will not be significantly affected by environmental risks. Furthermore, the inclusion of risk-based aspects would rather contradict the fundamental concept of the leverage ratio as a non-risk-based ratio.

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 would like to express that we are not in favor of using Pillar 1 measures to address climate risks. EAPB acknowledges the difficulties (mentioned in the report) of integrating ESG in a risk-based approach, such as:

o The Pillar 1 regime is grounded on data-driven risk-based considerations. This backward-looking approach (based on historical loss experience) will probably fail to capture the forward-looking elements of these risks.
o Climate-related events are uncertain and likely to grow over time, their evolution will arguably involve non-linearities and tipping points; due to these forward looking-aspects of environmental risks it is not possible to properly integrate these risks in the Pillar 1 framework in our opinion.
o There is a potential mismatch between the time horizon of the Pillar 1 framework and the long-term time horizon over which environmental risks are likely to fully materialize.
With regard to environmental risks we consider a risk-based approach to be meaningful.
Banks must assess default risks appropriately for maintaining financial stability of bank, the lending market, the banking sector and the financial system as such.

We agree with the risk-based approach of EBA’s discussion paper for assessing the prudential treatment of exposures, and also agree, that (historical) data and evidence is not available to allow an inclusion in the Pillar I framework.

Q7: What is your view on the appropriate time horizon (s) to be reflected in the Pillar 1 own funds requirements?

Environmental risks (transition as well as physical) are expected to materialize over a long time horizon which can be covered via Pillar II (discounting of future cashflows), but do not require a re-calibration of the 1-year Pillar I approach.
Any change to the current time horizon would have multiple unintended consequences with uncalculatable impact. For example, current capital ratios would change resulting in completely incomparable ratios and data.

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?

Pillar 1 is not the appropriate tool for reflecting environmental risks because the impact will be on micro level, not on macro level. Hence, no industry-wide measures are required but bank-specific analysis needs to be pursued, e.g. via Stress Testing and Scenario Analysis. The forward-looking nature of environmental risks should be mainly reflected in the economic perspective.

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?

Many institutions performed scenario-based sensitivity and stress analysis for transition and physical risk. The scenario analyses showed that for many banks transition risk is more material than physical risk for corporates and a in general a moderate impact of climate risks on portfolio level and certain sectors with higher impact depending on scenario.

We would like to highlight that the regulatory requirements towards statistical significance and explanatory power of a new (ESG related) risk driver in internal rating models are very high and not fulfilled at the moment.

Q12: Do you see any specific aspects of the CRM framework that may warrant a revision to further account for environmental risks?

Currently no. PD, LGD and “first of all” collateral valuations – as applicable to different type of exposures – remain the most appropriate analytical tools to condense the risk assessment of a counterparty, including its exposure to C&E risk. However, these parameters will be continuously reviewed in order to incorporate special cases of environmental risks.

Q13: Does the CRR3 proposal’s clarification on energy efficiency improvements bring enough risk sensitiveness to the framework for exposures secured by immovable properties? Should further granularity of risk weights be introduced, considering energy-efficient mortgages? Please substantiate your view.

From our point of view the CRR3 proposal’s clarification on energy efficiency improvements bring enough risk sensitiveness to the framework for exposures secured by immovable properties, since increasing physical risks should typically lead to decreased market value whereas mitigating transition risk by energy efficiency improvements should be taken into account by the determined market value.

Q14: Do you consider that high-quality project finance and high-quality object finance exposures introduced in the CRR3 proposal should potentially consider environmental criteria? If so, please provide the rationale for this and potential implementation issues.

Similar to the Infrastructure Support Factor, the definition of “high quality” project finance is already very restrictive; adding environmental criteria would basically align this concept to the ISF criteria, leading to the same usability / applicability issues.
In addition to that we understand that CRR suggests a lower risk weight for high quality project finance / object finance. This lower risk weight should reflect a better risk profile of such assets.

Given this understanding, we do not support the explicit consideration of environmental criteria for high-quality project finance and high-quality object finance exposures introduced in the CRR3 as it would contradict the overall risk-based approach to a certain extent. Still, environmental aspects should only be considered to the extent that they are relevant for the risk assessment.

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?

Based on current data availability a further risk differentiation is not justified. If additional data are being provided, these could be further analyzed in order to see whether this leads to a risk differentiation.

Q20: What are your views on potential strengthening of the environmental criterion for the infrastructure supporting factor? How could this criterion be strengthened?

We understand a proposal is being made under CRR3 for a separate risk weight category for project finance of 80% (20% relief). This would exist alongside the infrastructure supporting factor (25% relief). The discussion paper poses the question whether this is unnecessary and/or whether it might be better to reframe the infrastructure supporting factor as to encompass the environmental criteria. We can imagine that this indeed provides more clarity. For EAPB it is important that wind projects do not suddenly go to 80% rather than the 75% we currently adhere to.
In the event of removing the infrastructure supporting factor it is important to integrate the requirements that made a 75% risk weight possible, into the remaining sub-class

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.

We do not support adjustment factors to tackle environmental risks. As long as there is no clear evidence on increased default risks of exposures affected by environmental risks, there should not be any additional quantitative Pillar 1 requirements. For individual assessment, instruments in Pillar 2 are already taken into consideration.

Q23: What are your views on possible approaches to incorporating environmental risks into the FRTB Standardised Approach? In particular, what are your views with respect to the various options presented: increase of the risk-weight, inclusion of an ESG component in the identification of the appropriate bucket, a new risk factor, and usage of the RRAO framework?

We reject the addition of surcharges to risk weights based on forward-looking scenarios for various reasons. Such an approach breaks with the existing Basel Pillar I approach and would be based on very uncertain and subjective assessments of scenarios, which may have very different effects on individual institutions depending on the market risk positions concerned.

The addition of scenario analyses seems to us to be a very suitable risk management tool, although this should be subject purely to Pillar II. The more detailed derivation of the risk weight allocation based on the addition of certain relevant factors for environmental risk (e.g. dependence of the equity risk factor on, for example, economic activity and sector) would have to be clearly derivable empirically, but would then also be a strong generalization due to the lack of reflection of the concrete market price risk positions of an institution. The introduction of a new risk factor specifically for environmental risks is also subject to the proviso of empirical evidence of the impact of environmental risks on relevant instruments in the trading or banking book. In general, intensive Basel-level impact studies would be essential to verify the effects on capital adequacy and the precise calibration of capital approaches.

Q26: What additional information would need to be collected in order to understand how environmental risks impact banks’ operational risk? What are the practical challenges to identifying environmental risk losses on top of the existing loss event type classification?

First of all, we consider the existing event types to be sufficient, as they cover all sorts of events that could be caused by climate risks. In order to be able to identify losses from environmental risks, a flag additional to the existing event types could be introduced as proposed in the paper.

Main issue is the lack of an official universal taxonomy or categorisation of ESG risk predefined by supervision like Basel event type categorisation (including as well an example level 3, e.g. through EBA-guidelines).Likewise, EBA should give guidance for assigning loss data to the ESG risk categories for each Basel event type based on data available to EBA.

Q30: What, in your view, are the best ways to address concentration risks stemming from environmental risk drivers?

We support EBA’s opinion, that new concentration limits might have a negative impact on the financing of the counterparty’s transitioning to environmentally sustainable. Against this background we consider reporting and monitoring of potential concentration risk - complemented by Pillar 2 measures in case necessary – more effective. Tailor-made supervisory reactions based on meaningful / powerful reporting will prevent adverse effects on the transitioning. We therefore also agree with the discussion paper that an expansion of the existing Large Exposure Framework is not the correct path to address this perceived risk due to its focus on Groups of Connected Clients.

From the relevant section of the discussion paper, we understand that the potential thrust of such concentration risks is not limited to a high risk of natural catastrophes like flooding, earthquakes or wildfire, but could also potentially include steering of exposure concentrations to environmentally harmful sectors, like the mentioned carbon-intensive industries. In particular the latter should not be subject to financial regulation, since this would be an attempt to enforce non-financial goals through financial regulation.

Environmental risks should be defined as a horizontal risk driver for all relevant risk types in Pillar II / ICAAP to ensure detection of inter-risk-concentrations as defined in ECB’s Guide on climate related and environmental risks (“Consequently, physical and transition risks are drivers of existing risk, in particular credit risk, operational risk, market risk and liquidity risk, as well as non-Pillar 1 risks such as migration risk, credit spread risk in the banking book, real estate risk and strategic risk. Climate-related and environmental risks may, in fact, be drivers of several different risk categories and sub-categories of existing risk categories simultaneously.”).

Simulation of consistent environmental scenarios including all relevant risk types are to be conducted to clearly identify overall environmental risks as foreseen in the ECB Guide as well (“In line with the ECB Guide to the ICAAP, institutions are expected to consider in their forward-looking capital adequacy assessment any risks, and any concentration within and between those risks, that may arise from relevant changes in their operating environment.”). Currently, no relevant environmental concentration risk can be observed (at least short-term).

Regarding the current / future reporting requirements which are suitable to enable an effective monitoring of environmental related concentration risk we would like to point to further reporting requirements, institutions are obliged to comply with:

- Current LEX reporting: according to Art. 394 (1) S. 3 CRR institutions shall also report – as part of LEX – all exposures of a value greater or equal to €mn 300 (but less than 10 % of the institution's Tier 1 capital). The reporting (template LE1 / C27) comprises the residence and the sector (plus NACE code) of the counterparty. For large institutions a threshold of €mn 300 warrants the reporting of all significant counterparties.
- Current Pillar 3 disclosure and future ESG reporting: templates 2 and 3 of EBA/ITS/2022/01 on prudential disclosures on ESG risks in accordance with Art. 449a CRR already consists of a distinction between „exposures towards sectors that highly contribute to climate change” and “exposures towards sectors other than those that highly contribute to climate change”. Besides this for all banking book exposures classified as “towards a sector that highly contribute to climate change” a detailed granular sectoral breakdown is required.

- The disclosure templates mentioned could be integrated in the future ESG reporting requirements (according to art. 430 (1) h CRR III–draft) without any significant extra efforts for the institutions. Therefore, we do not see any need for an additional sectoral concentration reporting. If considered necessary, a similar geographical reporting could be integrated in the future ESG reporting.

- Overall, we consider the current reporting requirements including those already intended in CRR III-draft as sufficient to cover the prudential information needs regarding sectoral and geographical breakdowns. In regards of counterparty concentration risk a reporting threshold of €mn 300 is sufficient to cover all significant counterparty risks for large institutions. Before the implementation of new concentration reporting requirements is planned, the appropriateness of the current (or already intended) reporting requirements should be reviewed. If additional reporting requirements are considered necessary, those should be harmonized with the existing requirements to avoid any duplicative reporting requirements. To avoid an ongoing extension of reporting requirements – and reporting burden for institutions - the elimination of existing reporting requirements should be examined.

Q31: What is your view on the potential new concentration limit? Do you identify other considerations related to such a limit? How should such a limit be designed to avoid the risk of disincentivising the transition?

See Q30 +
It is said that the large exposure provision somewhat protects against concentration risks, but it says nothing about geographic exposures or environmental aspects. The question is therefore whether a specific concentration risk determination is also necessary in Pillar 1 from the point of view of sustainability. Given the geographic concentration of certain exposures, a specific concentration risk determination could turn out to be disadvantageous for an institution. It may also hinder promotional banks role. Moreover, considering the role that promotional banks can play in financing the transition, we believe that a concentration limit for promotional banks would be counterproductive in preventing environmental risks. Perhaps an exception for promotional banks is possible?
Concentrations risks are currently addressed under the economic perspective and incorporate several aspects (e.g. country, sector, individual). In our view, it is possible to add the environmental risk aspect to the existing framework of the economic perspective.

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