Response to discussion paper on the role of environmental risk in the prudential framework
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Second, the definition of capital should be expanded to encompass human, social and natural capital. Understanding the complex and dynamic relationships of the ecosystem services enables organizations to make more informed decisions (Natural Capital Protocol).
And third, the perspective should be shifted from shareholder value to system value. The system or societal value perspective accounts for internalization of externalities not captured by the market. For example, climate risks can be modelled as endogenous factor which is affected by banks’ investment decisions and can be evaluated in terms of natural capital loss (e.g. reduced air quality in monetary terms).
The prudential capital framework is an important and effective tool for supervisors to regulate banks’ (and other financial institutions) capital allocation and costs. Banks’ ESG risk assessments impact the cost of capital for their customers (via interest rates) which in turn affects their access to financing and investment (consumption) decisions. For environmental goals the regulatory capital framework can play a crucial role in assessing the risks and in the realization of the transition scenarios. Especially requirements under Pillar 1 can have immediate and direct effect on banks’ decision-making processes regarding risk undertaking, portfolio management and definition of business and sustainability strategy. It is therefore advisable to expand existing research and methodological developments / innovation towards integrating “double materiality” into the prudential framework for accelerating the transition towards low-carbon economy and achieving the SDGs. This will contribute significantly to financial stability and banks’ resilience in the long run, which is in line with the proposed risked-based approach by the EBA.
Q4: Should the ‘double materiality’ concept be incorporated within the prudential framework? If so, how could it be addressed?
The perspective of “double materiality” is fundamental for the management of ESG risks. For example, the feedback loop of finance-economy-climate is considered important for financial supervisors to tackle climate risks through macro-prudential policies and disclosures and represents a knowledge gap in existing research (2022 ECB DP 2665 Regis et al.). In order to be consistent with the provisions of current and future regulatory requirements such as SFDR and the CSRD, the “double materiality” concept should be adopted within the capital prudential framework for financial institutions. However, under the Pillar 1 capital requirements the current focus on material risks for financial capital from enterprise value perspective is too narrow. Therefore, from methodological point of view a big leap is needed to address double materiality. First, the capital prudential framework should take a holistic perspective to include environmental and social (societal) materiality beyond financial materiality. This is in line with the concept of materiality made by the NFSG.Second, the definition of capital should be expanded to encompass human, social and natural capital. Understanding the complex and dynamic relationships of the ecosystem services enables organizations to make more informed decisions (Natural Capital Protocol).
And third, the perspective should be shifted from shareholder value to system value. The system or societal value perspective accounts for internalization of externalities not captured by the market. For example, climate risks can be modelled as endogenous factor which is affected by banks’ investment decisions and can be evaluated in terms of natural capital loss (e.g. reduced air quality in monetary terms).
The prudential capital framework is an important and effective tool for supervisors to regulate banks’ (and other financial institutions) capital allocation and costs. Banks’ ESG risk assessments impact the cost of capital for their customers (via interest rates) which in turn affects their access to financing and investment (consumption) decisions. For environmental goals the regulatory capital framework can play a crucial role in assessing the risks and in the realization of the transition scenarios. Especially requirements under Pillar 1 can have immediate and direct effect on banks’ decision-making processes regarding risk undertaking, portfolio management and definition of business and sustainability strategy. It is therefore advisable to expand existing research and methodological developments / innovation towards integrating “double materiality” into the prudential framework for accelerating the transition towards low-carbon economy and achieving the SDGs. This will contribute significantly to financial stability and banks’ resilience in the long run, which is in line with the proposed risked-based approach by the EBA.