Banks to amend risk assessment amid ESG rule changes

European banks are facing a transformative shift as they adapt to new environmental, social, and governance (ESG) requirements imposed by regulatory authorities. The European Banking Authority (EBA) is at the forefront of this movement, revising the industry-wide capital requirements framework, known as Pillar 1, to incorporate ESG factors. This groundbreaking effort will mandate banks to reevaluate default and loss probabilities, as well as the risk weights used to determine the capital reserves allocated to each client account. The EBA’s initiative is expected to have significant implications for high-emission sectors such as oil, gas, cement, steel, and mining.

Under this new framework, addressing ESG risks will be a central focus for banks. The EBA’s framework builds upon existing rules that already allow banks to take a forward-looking approach, enabling swift progress in this area. This approach is in line with a global trend, as various banking and financial stability organisations worldwide are also revising reporting and capital frameworks to incorporate climate-related financial risks.

Notably, the EBA’s effort represents a pioneering move, as it’s the first authority to publish specific recommendations on how to integrate E&S (environmental and social) risk considerations into the prudential framework. Nevertheless, there are concerns, particularly from the European Banking Federation (EBF), which believes that there may be insufficient data to justify these Pillar 1 ESG adjustments, as opposed to Pillar 2 rules tailored to individual banks.

The key concern is to ensure that the prudential framework remains evidence-based and risk-oriented. It is crucial that any comprehensive revision of Pillar 1 or a macro-prudential framework happens on a global scale to create a level playing field for EU banks.

The shift towards ESG assessments will inevitably require banks to allocate additional resources. Financial supervisors are focusing on Pillar 1 due to its discipline and resources invested by banks in compliance, making it a more feasible route for regulators to follow. ESG-related losses are expected to become more correlated, which will impact traditional financial risk categories such as credit, market, and operational risks.

To meet these new requirements, banks and their supervisors will need to reassess collateral values, incorporate environmental risks into trading book budgets, adjust internal risk models, and adapt default probabilities. However, implementing these measures will come with costs related to data collection and model development to effectively reflect the role of E&S factors.

Several major banks have already initiated changes to align with these ESG requirements. For instance, BNP Paribas extended restrictions on fossil fuel lending in its capital markets business, and ING Groep’s German unit announced its rejection of clients without credible emissions-reduction plans.

This regulatory push is in response to institutional investors’ growing impatience with banks and their desire for these financial institutions to use their influence to direct capital away from heavy emitters and toward green clients. Moreover, banks that do not align with these changes face the threat of litigation.

The EBA’s recent ESG requirements are only the beginning of a series of adjustments that will bring ESG assessments into the day-to-day operations of the banking industry. This shift toward ESG integration is an ongoing process, with the industry striving to build metrics based on actual evidence and data for environment-related concentration risk. It is an evolving landscape where regulatory authorities are actively reshaping the future of banking to account for ESG considerations.