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

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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?

There are short term answers (like the temporary adjustments proposed with the two SAF amendments that ABI proposes, see Q21) and medium- long term answers.
For the latter, as stated in the discussion paper, simplicity and risk sensitivity need to be balanced. However, if the objective is to integrate environmental risks, while risk differentiation in the corporate exposure class may probably be justified, it cannot be done only at the level of a sector but at the level of the counterparty as it has been done in climate stress tests. Indeed, if the sector can give a good indication of clients that are more exposed to environmental risks, it is not sufficient to assess the real risks: it can depend on many parameters like the commitment of the client to transition, its cost of production etc.
As mentioned above regarding the incorporating of a forward-looking perspective, the risk differentiation across corporate counterparties can be better assessed over the medium term based on expert opinion in a first stage, subject to a long-term view on the company that includes an analysis of its transition plan. Scenario analysis could be a useful instrument as well to understand the risk profile of different counterparties.
Differentiation in the retail class would be more challenging and perhaps too complex.

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.

Any change or adjustment should be risk based.
We consider important that banks, regulators and supervisors work together to develop the methodologies that can include the forward-looking aspect of climate risk and long-term horizons in the risk management framework.
Banks are part of the solution to achieve the objective of net-zero greenhouse gas (GHG) emissions in the EU economy by 2050 but they should not be the primary enforcers of the EU climate policy. There is a political responsibility in defining the relevant industrial and tax policies that could ensure an orderly transition and limit transition and physical risk levels, for both climate and financial stability purposes. This was rightfully exposed by the Bank of England in its statement: ”regulatory capital cannot substitute for government climate policy”(*) .
In this context, any comprehensive bank supervisory treatment of climate risk will benefit of the definition by the European Union of a detailed transition path towards a decarbonized economy by 2050 at a granular level, by industrial sector and by country, taking into account the industrial implications of a successful transition. A key aspect of banking supervisory assessment should also be and remain the assessment of banks’ risk management framework of climate risk and the insertion of climate risk-related considerations in decision making processes, in particular credit origination. The assessment of climate risk management frameworks and of the adherence to well defined transition paths by public authorities should form the basis of supervisory work; in case of deficiencies identified on either count, supervisors could take corrective measures, by way of Pillar 2 capital measures (add-ons).
We believe that non-risk-based Pillar 1 changes in order to increase capital requirements, such as the Brown Penalizing Factor would be pure political measures. These latter should be addressed through public policies or taxes and not through banking regulation. In addition, a non-risk-based approach would be counter-productive in terms of risks and transition finance.
A good credit is not always sustainable; sustainable exposures can be bad credits. But it could also be the case that exposures to some sort of sustainable economic activity can have a reduced prospective credit risk and this can not be adjusted under Pillar 2 (only add-ons). Therefore, in order to balance the only Pillar2 approach and foster the transition in a risk based manner, we propose to introduce a dedicated adjustment factor named Sustainability adjustment factor (SAF) for both 1) energy efficient mortgages and 2) other suitable exposures. The aim is to steer capital flows towards sustainable economic activities and at the same time allocate credit to the less risky ones.
The first proposal aims to apply a sound treatment to mortgage credit in order to encourage lenders to grant these loans which can contribute to: (i) reduce the energy consumption and greenhouse gas emission; (ii) achieve the EU target for zero-emission building stock by 2050 contained in Commission Work Programme “Fit for 55” package. This preferential treatment would also encourage lenders to apply better condition to mortgage loans, pushing the demand for this kind of credit. The proposal is also in line with the purpose of Energy Performance of Buildings Directive (EPBD).
The second one, is less precisely defined because it is based on the idea of suitable exposures that need to be identified. Suitable exposures are related to to cluster of taxonomy aligned exposures identified by EBA via sample based forward-looking methodologies and that are characterized by a reduce prospective financial risk. In this respect, a more precise mandate is needed for EBA to study other asset classes in view of an extension of the adjustment, based on evidence of reduced riskiness of exposures by virtue of their environmental sustainability.
Both proposals are temporary and risk based. Both are based on a mechanism similar to other supporting factors (to be applied after traditional RWA calculation, and therefore meant for both STA and IRB) and applicable only to well identified exposures. By construction SAF does not have double counting issues because it can be applied only until banks will have validated models that integrate ESG factors or until the standard prudential framework will split sustainable and non-sustainable exposures.
The adoption of SAF would not affect risk management activities: its application would not exempt banks from a prior creditworthiness analysis, applying only after having calculated their capital requirements as usual. The SAF would be applied as a “discount at checkout”, similar to the SME support factor.
SAF would foster the message that sustainable economic activity can have positive financial effects on enterprises risk profiles. Not taking into account this could have the unintentional effect of penalising these economic activities in respect to the others as long as long term solution will be ad disposal (validated IRB/IRBA models that integrate ESG risk drivers and/or some dedicated asset classes under the SA).

(*) Climate-related financial risk management and the role of capital requirements, Bank of England, PRA, 28 October 2021

Name of the organization

ABI - Italian Banking Association