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Banking for Future

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.
The risk of Greenwashing should be introduced as risk factor on a stand-alone basis in the credit risk framework. Greenwashing can lead to underestimated ESG risks. A distorted picture of the environmental impact of investments increases the unexpected losses, if the transition and physical risks materialize. Counterparty’s financial situation and even solvability can be significantly harmed, which should be reflected in the estimation of credit risk parameters such as PDs and LGDs. The risk of Greenwashing increases market credit spreads (as evidenced by recent research) and should be therefore incorporated into the credit risk assessments. The uncertainty of credit quality in respect to sustainability aspects needs to be priced in the risk premia for better capital allocation. This is in line with the proposed risk-based approach by the EBA.
The risk of Greenwashing should be introduced as risk factor on a stand-alone basis in the credit risk framework (see above answer to Q16).
The risk of Greenwashing should be introduced as risk factor on a stand-alone basis in the market risk framework. Assets that have been affected by Greenwashing can lose significantly in market value and even become stranded, so they cannot be sold. This uncertainty should be reflected in the market risk parameters such as Value-at-Risk for example.
The risk of Greenwashing should be introduced as risk factor on a stand-alone basis in the operational risk framework. The risk of Greenwashing emerges when there are no practices to identify it or they are inadequate due to lack of knowledge. When relying on false or bad quality data provided by external counterparties, financial institutions unconsciously run the risk of misleading investors and other stakeholders towards sustainable activities. Also, the lack of internal control mechanism on Greenwashing prevention allows for intentional misconduct and fraud by employees, if for example their remuneration is linked to “green” market activities (which is encouraged by regulators). It is also possible to mislead investors, when the sustainable investments cannot meet the eligibility criteria provided in the pre-contractual disclosures.
Banking for Future