Response to discussion paper on the role of environmental risk in the prudential framework
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We have no comments on the Leverage Ratio related aspects of the paper.
Even when external credit rating provides a description of the applied methodology, the provided description can be limited and not provide the insights required by firms for their decision making. We believe there is a case for harmonization of standards on the part of external credit rating agencies as providers of information to regulated firms.
In any case, the extension of the due diligence requirements must follow the proportionality principles.
From the consumer point of view, people owning older houses and still repaying their mortgages could face an increase of the interest rate to capture for non-energy-efficiency of their houses, particularly where the options to further increase energy efficiency of old stock are limited. There are significant concerns around equity and proportionality of such measures.
Further splits would only be justified if we have strong empirical evidence that this split is necessary. In addition, any split will require banks to collect additional data to be able to split their portfolio in a more granular way
We recommend first gathering enough empirical evidence before implementing any additions to the SA framework.
Based on our exchange with our client, the best way to proceed is to invest in collecting historical data to measure environmental risks.
Starting from 2027, the banks would have sufficient data on new definition of default and thus, they might be required to reassess their internal models. In this phase banks could be asked to integrate the environmental risks into their model.
Considering our experience in developing IRB models, we see 2 possibilities to reflect environmental risk:
- Risk differentiation: Environmental risks as potential risk drivers
- Add-on: Impact from the environmental risk could be assessed similar to the current methodology of downturn. We would then assess the impact for instance by sectors, and if certain limits are breached then an add-on will be added to cover environmental risks.
In the meantime, the banks could use their regular backtesting processes to assess the impact of potential new risk drivers (environmental variables) on their models.
- Risk differentiation: Environmental risks as potential risk drivers
- Add-on: Impact from the environmental risk could be assessed similar to the current methodology of downturn. We would then assess the impact for instance by sectors, and if certain limits are breached then an add-on will be added to cover environmental risks.
- Integration of a specific factor at sector level -> more conservative approach
- Alignment with GAR:
o GAR=100%, then he adjustment factor can be reduced to 75%
o GAR=0 -> check the economic activity
In order to understand how these environmental risks could impact banks’ operational risk profiles, detailed information on the location of the bank’s physical assets against areas most exposed to physical environmental risk events (e.g., areas more prone to flooding; areas where severe storms are more likely to occur; areas exposed to rising temperatures and the threat of wildfires) would need to be gathered and maintained. However, even if banks did have access to this information, modelling potential future losses based on this information remains challenging as where precisely the event would crystallise, and the nature and size of the impacts from crystallisation on the bank, are difficult to predict.
Environmental risk losses can be mapped to the existing operational risk loss event types but it should better to create a dedicated taxonomy in order to separate ESG Risk from Operational Risk. The different types of environmental risks, and the related transmission channels to traditional financial risks at a conceptual level, are relatively well defined. Based on this, when environmental risk events crystallise, it should be straightforward to identify these losses from an operational risk perspective. The practical challenges associated with environmental risks do not relate to classification, but to forecasting in terms of timing, frequency and magnitude. For this reason it would be useful for banks to start enriching the current loss archive with ESG information, thus integrating the current historical series with new information (i.e. geographical data, event characteristics, …) and start tracking ESG events and metrics from now on.
Due to the fact that single banks do not have enough data to develop a consistent loss archive that would allow to build a model , it would be necessary to develop a centralized archive available to every bank in order to retrieve all the existing/available information related to ESG events previously occurred.
Alternatively, ECB should identify an official data provider which will be in charge of collecting and providing this information.
Another practical challenge that environmental risks pose relate to correlation. Crystallised environmental risk events could lead to operational losses for a bank as extreme weather events damage physical assets and disrupt business operations while also negatively affecting the credit quality of the bank’s clients / borrowers. The traditionally firm-specific view of operational risk and operational risk capital would not adequately capture the broader systemic impacts from crystallised environmental risk events.
Overall, environmental risks are captured indirectly in the current operational risk framework as drivers of the existing event categories. This could be comprehensively mapped and formalised to ensure consistency in terms of approach. While additional information could be collated to try and quantify the potential impacts of environmental risks on operational risk losses, the nature of these risks present significant modelling challenges. In addition, the firm-specific nature of operational risk under the current framework makes it unsuitable to adequately capture all of the impacts from crystallised environmental risk events.
Integration of ESG factors in the Operational Risk Framework
Integrating a forward-looking perspective into the operational risk framework to account for environmental events will not overcome the key challenges. Physical environmental risks, the type that are likely to impact operational risk the most, are the most challenging to predict when compared to transition risks. Even if banks can source and maintain granular climate and environmental data that shows qualitatively the physical assets most exposed and where operations are more likely to be disrupted, actually quantifying the impacts should these environmental risk events occur is extremely challenging. Specifically, forecasting the timing, frequency and magnitude of environmental risk events is difficult.
Another consideration is the objective of the Standardised Approach. Given the numerous variables, considerations and channels through which environmental risk events could crystallise, any forward-looking component would require relatively sophisticated modelling in order to be meaningful; this would diverge from the existing Standardised Approach which should be accessible, understandable and not overly burdensome to implement for firms of all sizes and levels of sophistication.
In addition, introducing a forward-looking perspective into the operational risk framework, if it was to be done, would need to consider all operational loss event types, not just environmental risk events. These other existing operational loss event types are consistent with environmental risk events in that there is limited historical data to utilise and the ability to forecast timing, frequency and magnitude is very difficult.
Overall, integrating a forward-looking perspective into the operational risk framework would not overcome the key challenges and introduce new complexities that could have the unintended consequence of overburdening firms.
Creation of a dedicated ESG Framework
It could be possible to foresee the development of a new ESG framework (database, models, reporting) in order to track and manage the ESG events. The complexity of this new framework could be manage considering the specificity of each bank in term of dimension, complexity, geographical extension.
The development of this framework would involve the creation of an ESG framework which is independent from the operational risk and is based on three points:
1. Collection of the loss data related to ESG events through a specific Event Type Taxonomy in order to create a data base
2. Perform a self-evaluation of the risks through the Risk Self-Assessment questionnaire, also including scenario analysis that consider expected loss and worst-case scenario which would grant a forward-looking view
3. Implementation of a model which starting from the baseline (historical loss data) applies corrective factors retrieved from the evidences obtained through the Risk Self-Assessment
The activities that should be performed within this framework are the following:
1. Build up an internal archive of the ESG-related losses (starting from the existing loss data archive, highlight the events related to ESG events and the related attributes – e.g., insurances-related reimbursement, dates, … – in order to obtain historical series. Meanwhile, it would be necessary to adopt process and instruments aimed at intercept and describe the ESG-related losses expected in the future – also retrieving additional information on climatic/environmental events, earthquake magnitude, …).
2. Develop of an ECB centralized archive which retrieve the main info provided by each bank and made these available to all the financial institution in order to allow to build up models based on wide and deep ESG loss data (e.g., DIPO).
3. ECB should consider the information collected by each bank in order to:
3.1. develop an ESG standardised framework to be adopted by all the supervised banks
3.2. provide the supervised banks with the option to develop internal models.
If we consider, on one hand, the wide-ranging impacts and the high degree of uncertainty around the timing of materialisation of environmental risks and, on the other, the methodologies and data used to analyse and measure these risks, are currently evolving, we would suggest the adoption of a standardised framework (which is also simpler for small banks).
In order to include the forward-looking approach, it would be possible to integrate the Risk Self-Assessment defining new questionnaire with new scales of probability and magnitude related to the climate risk and retrieving information on the expected loss and worst case related to ESG events.
In order to define an approach which is backward- and forward-looking it is possible to define a model which consider a baseline (based on historical ESG loss data) and applies corrective factors (which consider information retrieved through the Risk Self-Assessment). This model should consider the distribution of the events which usually have a high tail risk.
A key difference between environmental events and the existing operational loss event categories is the fact that the existing categories are firm-specific whereas crystallised environmental risk events are likely to have much broader systemic consequences, and be correlated to the credit riskiness of a bank’s portfolio.
We don’t see the integration of a forward-looking component, or formal inclusion of an environmental risk specific component, into the existing pillar 1 framework as the optimal approach for operational risk. Doing so would have the unintended consequence of adding undue complexity to the Standardised Approach thus presenting challenges to smaller and less sophisticated banks, and it could be viewed as forcing a Microprudential framework on an issue that has broader systemic consequences.
Our overarching view is therefore that environmental risks should not be captured in the pillar 1 operational risk framework. Including a non-financial risk component to the macroprudential climate scenarios, such as the climate biennial exploratory scenario by the Bank of England and the climate stress test by the ECB, to calibrate systemic buffers to be held by banks with the most material contributions to the overall level of environmental risk in the system, would be a more suitable approach.
Nonetheless, environmental risks still need to be managed and, in order to ensure there is an effective risk management framework, banks should define/develop:
· risk mitigating measures to effectively manage these risks such as, but not limited to, underwriting insurance product, organizational processes, infrastructural investment, internal policies, procedures, control update
· qualitative and/or quantitative metrics or indicators to assess, monitor, and report ESG risks;
· internal risk reporting practices to ensure effective decision-making and standardised reporting ESG risk to regulatory compliance purposes.
- Risk to client -> reason = Greenwashing resulting from the operational risk
- Risk to firm -> Reason = Greenwashing due to the reputational risk and operational risk
From our point of view, Risk-to-market has very limited exposure to environmental risks.
We consider that investment firms should start like banks stress test climate risk stemming from transition risk. This will allow they the assessment of the direct exposures towards climate risk.
- Counterparty risk
-Liquidity risk
- Skills needed to implement the requirement for Pillar I
- Data gathering is required
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?
The climate risk represented exogenously by the degree of liquidity of ESG financial instruments (e.g. green bond, social bond, sustainability linked bond) could impact the determination of the NSFR, as a possible HQLA encumbered for a period of six months or more and less than one year.We have no comments on the Leverage Ratio related aspects of the paper.
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?
We believe significant work needs to be undertaken in relation to establishing standards around ESG related data. This work should leverage the enhancements made in the industry through compliance with BCBS239 initiatives.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?
The assessment of forward-looking components needs good quality historical data. At the moment, there is no sufficient reliable data to appropriately measure environmental risk. Thus, we would suggest first concentrating on data gathering and data harmonization processes. This would require significant standard setting and practice harmonization.Q10: What are the main challenges that credit rating agencies face in incorporating environmental considerations into credit risk assessments? Do you make use of external ratings when performing an assessment of environmental risks?
As a consulting firm supporting financial institutions with implementation of climate risks, we face an issue of transparency and comparability of the methodologies used by the external credit rating agencies when integrating the environmental risks into credit risk assessment.Even when external credit rating provides a description of the applied methodology, the provided description can be limited and not provide the insights required by firms for their decision making. We believe there is a case for harmonization of standards on the part of external credit rating agencies as providers of information to regulated firms.
Q11: Do you see any challenge in broadening due diligence requirements to explicitly integrate environmental risks?
The extension of the due diligence can become an additional burden to financial institutions. Before extending the due diligence requirements, we consider that it is more appropriate first to do a robust assessment of the impacts of environmental risks on the financial institution operations and balance sheet. Not all institutions will face the same level of environmental risks.In any case, the extension of the due diligence requirements must follow the proportionality principles.
Q12: Do you see any specific aspects of the CRM framework that may warrant a revision to further account for environmental risks?
We consider that funded credit protection (FCP) could be a good starting point to account for environmental risk. This can be implemented in the collateral evaluation requirements.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.
We do not consider that the CRR3 risk weights must be further adjusted to consider energy-efficient mortgages. This additional split will require additional clarification on how to measure the energy-efficiency of mortgages. In addition, it could cause a kind of “greenwashing effect” on the market.From the consumer point of view, people owning older houses and still repaying their mortgages could face an increase of the interest rate to capture for non-energy-efficiency of their houses, particularly where the options to further increase energy efficiency of old stock are limited. There are significant concerns around equity and proportionality of such measures.
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.
We consider that prior to the changes of the CRR3, we must have stable analysis of impact between the environmental criteria and project finance.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?
We do not consider that at the current state, the further split would be justified.Further splits would only be justified if we have strong empirical evidence that this split is necessary. In addition, any split will require banks to collect additional data to be able to split their portfolio in a more granular way
Q16: Do you have any other proposals on integrating environmental risks within the SA framework?
We consider that there is lack of reliable historical data and empirical research that proves a relation between the environmental risks and RWA.We recommend first gathering enough empirical evidence before implementing any additions to the SA framework.
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?
We consider that it is not the right moment to review the IRB framework. Currently, most of the banks are involved in long-term IRB-repair programs where they are also re-designing their internal models. These projects will go on for the next 2-3 years.Based on our exchange with our client, the best way to proceed is to invest in collecting historical data to measure environmental risks.
Starting from 2027, the banks would have sufficient data on new definition of default and thus, they might be required to reassess their internal models. In this phase banks could be asked to integrate the environmental risks into their model.
Considering our experience in developing IRB models, we see 2 possibilities to reflect environmental risk:
- Risk differentiation: Environmental risks as potential risk drivers
- Add-on: Impact from the environmental risk could be assessed similar to the current methodology of downturn. We would then assess the impact for instance by sectors, and if certain limits are breached then an add-on will be added to cover environmental risks.
In the meantime, the banks could use their regular backtesting processes to assess the impact of potential new risk drivers (environmental variables) on their models.
Q18: Have you incorporated the environmental risks or broader ESG risk factors in your IRB models? If so, can you share your insight on the risk drivers and modelling techniques that you are using?
In our current projects, our clients did not have sufficient historical data to include on their IRB models.Q19: Do you have any other proposals on integrating environmental risks within the IRB framework?
Considering our experience in developing IRB models, we see 2 possibilities to reflect environmental risk:- Risk differentiation: Environmental risks as potential risk drivers
- Add-on: Impact from the environmental risk could be assessed similar to the current methodology of downturn. We would then assess the impact for instance by sectors, and if certain limits are breached then an add-on will be added to cover 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 complexity of the calculation of the adjustment factors, we see two possibilities:- Integration of a specific factor at sector level -> more conservative approach
- Alignment with GAR:
o GAR=100%, then he adjustment factor can be reduced to 75%
o GAR=0 -> check the economic activity
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?
Based on our experience on market risk framework and the application of the Basel framework, the climate risk framework involved two important needs: the requirement to manage the new risk factor “climate” and the opportunity of rewarding investments in green financial instruments. Changing the Risk Weights is difficult as there is no historical evidence of the impacts on market prices deriving from climate risk. A potential method could be to introduce the "Climate risk factor” as an add-on as to date there are no empirical evidence and models for the calculation of SBA metrics (Delta, Vega, Curvature) and impacts on the DRC.Q24: For the Internal Model Approach, do you think that environmental risks could be better captured outside of the model or within it? What would be the challenges of modelling environmental risks directly in the model as compared to modelling it outside of the internal model? Please describe modelling techniques that you think could be used to model ESG risk either within or outside of the model.
As mentioned in this discussion paper, since there is no historical evidence of the impacts on prices caused by climate risks, it is problematic to calibrate the historical scenarios aimed at calculating the Expected Shortfall. The suggested method is to introduce the "Climate risk factor” as an add-on of the capital charge.Q25: Do you have any other proposals on integrating environmental risks within the market risk framework?
Regarding the framework, we suggest what is reported in the answers to questions 23 and 24. However, to facilitate the process of ecological transition (ref. Paris Climate Agreement 2015), it is important to encourage financial institutions to purchase green financial products. In this regard, the regulator could consider benefits in the capital charge (eg lower risk weights for SA-FRTB or benefits in liquidity horizon for IMA purposes).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?
Physical environmental risks are the most relevant when considering the impact on operational risk. Acute events such as wildfires, heat waves, floods and storms, and chronic changes such as sea level rises and changes in precipitation could lead to internal losses for banks, mainly by damaging physical assets or disrupting business operations.In order to understand how these environmental risks could impact banks’ operational risk profiles, detailed information on the location of the bank’s physical assets against areas most exposed to physical environmental risk events (e.g., areas more prone to flooding; areas where severe storms are more likely to occur; areas exposed to rising temperatures and the threat of wildfires) would need to be gathered and maintained. However, even if banks did have access to this information, modelling potential future losses based on this information remains challenging as where precisely the event would crystallise, and the nature and size of the impacts from crystallisation on the bank, are difficult to predict.
Environmental risk losses can be mapped to the existing operational risk loss event types but it should better to create a dedicated taxonomy in order to separate ESG Risk from Operational Risk. The different types of environmental risks, and the related transmission channels to traditional financial risks at a conceptual level, are relatively well defined. Based on this, when environmental risk events crystallise, it should be straightforward to identify these losses from an operational risk perspective. The practical challenges associated with environmental risks do not relate to classification, but to forecasting in terms of timing, frequency and magnitude. For this reason it would be useful for banks to start enriching the current loss archive with ESG information, thus integrating the current historical series with new information (i.e. geographical data, event characteristics, …) and start tracking ESG events and metrics from now on.
Due to the fact that single banks do not have enough data to develop a consistent loss archive that would allow to build a model , it would be necessary to develop a centralized archive available to every bank in order to retrieve all the existing/available information related to ESG events previously occurred.
Alternatively, ECB should identify an official data provider which will be in charge of collecting and providing this information.
Another practical challenge that environmental risks pose relate to correlation. Crystallised environmental risk events could lead to operational losses for a bank as extreme weather events damage physical assets and disrupt business operations while also negatively affecting the credit quality of the bank’s clients / borrowers. The traditionally firm-specific view of operational risk and operational risk capital would not adequately capture the broader systemic impacts from crystallised environmental risk events.
Overall, environmental risks are captured indirectly in the current operational risk framework as drivers of the existing event categories. This could be comprehensively mapped and formalised to ensure consistency in terms of approach. While additional information could be collated to try and quantify the potential impacts of environmental risks on operational risk losses, the nature of these risks present significant modelling challenges. In addition, the firm-specific nature of operational risk under the current framework makes it unsuitable to adequately capture all of the impacts from crystallised environmental risk events.
Q27: What is your view on potential integration of a forward-looking perspective into the operational risk framework to account for the increasing severity and frequency of physical environmental events? What are the theoretical and practical challenges of introducing such a perspective in the Standardised Approach?
Providing the answer we would like to focus both on the challenges related to the introduction of the environmental risks within the standardised approach and on the chance to develop a stand-alone environmental risk framework.Integration of ESG factors in the Operational Risk Framework
Integrating a forward-looking perspective into the operational risk framework to account for environmental events will not overcome the key challenges. Physical environmental risks, the type that are likely to impact operational risk the most, are the most challenging to predict when compared to transition risks. Even if banks can source and maintain granular climate and environmental data that shows qualitatively the physical assets most exposed and where operations are more likely to be disrupted, actually quantifying the impacts should these environmental risk events occur is extremely challenging. Specifically, forecasting the timing, frequency and magnitude of environmental risk events is difficult.
Another consideration is the objective of the Standardised Approach. Given the numerous variables, considerations and channels through which environmental risk events could crystallise, any forward-looking component would require relatively sophisticated modelling in order to be meaningful; this would diverge from the existing Standardised Approach which should be accessible, understandable and not overly burdensome to implement for firms of all sizes and levels of sophistication.
In addition, introducing a forward-looking perspective into the operational risk framework, if it was to be done, would need to consider all operational loss event types, not just environmental risk events. These other existing operational loss event types are consistent with environmental risk events in that there is limited historical data to utilise and the ability to forecast timing, frequency and magnitude is very difficult.
Overall, integrating a forward-looking perspective into the operational risk framework would not overcome the key challenges and introduce new complexities that could have the unintended consequence of overburdening firms.
Creation of a dedicated ESG Framework
It could be possible to foresee the development of a new ESG framework (database, models, reporting) in order to track and manage the ESG events. The complexity of this new framework could be manage considering the specificity of each bank in term of dimension, complexity, geographical extension.
The development of this framework would involve the creation of an ESG framework which is independent from the operational risk and is based on three points:
1. Collection of the loss data related to ESG events through a specific Event Type Taxonomy in order to create a data base
2. Perform a self-evaluation of the risks through the Risk Self-Assessment questionnaire, also including scenario analysis that consider expected loss and worst-case scenario which would grant a forward-looking view
3. Implementation of a model which starting from the baseline (historical loss data) applies corrective factors retrieved from the evidences obtained through the Risk Self-Assessment
The activities that should be performed within this framework are the following:
1. Build up an internal archive of the ESG-related losses (starting from the existing loss data archive, highlight the events related to ESG events and the related attributes – e.g., insurances-related reimbursement, dates, … – in order to obtain historical series. Meanwhile, it would be necessary to adopt process and instruments aimed at intercept and describe the ESG-related losses expected in the future – also retrieving additional information on climatic/environmental events, earthquake magnitude, …).
2. Develop of an ECB centralized archive which retrieve the main info provided by each bank and made these available to all the financial institution in order to allow to build up models based on wide and deep ESG loss data (e.g., DIPO).
3. ECB should consider the information collected by each bank in order to:
3.1. develop an ESG standardised framework to be adopted by all the supervised banks
3.2. provide the supervised banks with the option to develop internal models.
If we consider, on one hand, the wide-ranging impacts and the high degree of uncertainty around the timing of materialisation of environmental risks and, on the other, the methodologies and data used to analyse and measure these risks, are currently evolving, we would suggest the adoption of a standardised framework (which is also simpler for small banks).
In order to include the forward-looking approach, it would be possible to integrate the Risk Self-Assessment defining new questionnaire with new scales of probability and magnitude related to the climate risk and retrieving information on the expected loss and worst case related to ESG events.
In order to define an approach which is backward- and forward-looking it is possible to define a model which consider a baseline (based on historical ESG loss data) and applies corrective factors (which consider information retrieved through the Risk Self-Assessment). This model should consider the distribution of the events which usually have a high tail risk.
Q28: Do you agree that the impact of environmental risk factors on strategic and reputational risk should remain under the scope of the Pillar 2 framework?
Yes. For the reasons set out previously, we do not think the pillar 1 operational risk framework should be adjusted in any way to take into consideration environmental risks, including the treatment of strategic and reputational risks. In the near future, once evaluated the real impact of Enviromental Risk, its integration within the overall framework could be reviewed.Q29: Do you have any other proposals on integrating environmental risks within the operational risk framework?
Environmental risks are currently captured indirectly in the operational risk framework as losses from crystallised environmental risk events can be mapped for operational risk purposes. Ensuring this is comprehensive and formalised to ensure consistency would be beneficial for firms and regulators.A key difference between environmental events and the existing operational loss event categories is the fact that the existing categories are firm-specific whereas crystallised environmental risk events are likely to have much broader systemic consequences, and be correlated to the credit riskiness of a bank’s portfolio.
We don’t see the integration of a forward-looking component, or formal inclusion of an environmental risk specific component, into the existing pillar 1 framework as the optimal approach for operational risk. Doing so would have the unintended consequence of adding undue complexity to the Standardised Approach thus presenting challenges to smaller and less sophisticated banks, and it could be viewed as forcing a Microprudential framework on an issue that has broader systemic consequences.
Our overarching view is therefore that environmental risks should not be captured in the pillar 1 operational risk framework. Including a non-financial risk component to the macroprudential climate scenarios, such as the climate biennial exploratory scenario by the Bank of England and the climate stress test by the ECB, to calibrate systemic buffers to be held by banks with the most material contributions to the overall level of environmental risk in the system, would be a more suitable approach.
Nonetheless, environmental risks still need to be managed and, in order to ensure there is an effective risk management framework, banks should define/develop:
· risk mitigating measures to effectively manage these risks such as, but not limited to, underwriting insurance product, organizational processes, infrastructural investment, internal policies, procedures, control update
· qualitative and/or quantitative metrics or indicators to assess, monitor, and report ESG risks;
· internal risk reporting practices to ensure effective decision-making and standardised reporting ESG risk to regulatory compliance purposes.
Q32: With reference to the three risk categories the IFR is based on (Risk-to-Client, Risk-to-Market and Risk-to- Firm), which of these could be related to environmental risks, and to what extent?
Based on our experience and exchange with the investment firms, the following risks can be related to environmental risks:- Risk to client -> reason = Greenwashing resulting from the operational risk
- Risk to firm -> Reason = Greenwashing due to the reputational risk and operational risk
From our point of view, Risk-to-market has very limited exposure to environmental risks.
Q33: Should any of the existing K-factors incorporate explicitly risks related to environmental factors?
In the case of Risk-to-client, we consider that the K-AUM will be the relevant K-factor to consider.Q35: Do you have any other suggestions as to how the prudential framework for investment firms could be adjusted to account for environmental risk factors?
At the moment, investment firms have made progress in disclosing indirect exposures, but not direct exposure. TFCD disclosures confirm our observation.We consider that investment firms should start like banks stress test climate risk stemming from transition risk. This will allow they the assessment of the direct exposures towards climate risk.
Any other comments?
We think that also the following areas must be considered in the context of this discussion:- Counterparty risk
-Liquidity risk
- Skills needed to implement the requirement for Pillar I
- Data gathering is required