ESG and risk management: where banks stand today

In recent years, environmental, social and governance risks – commonly referred to as ESG risks – have received a large amount of attention from supervisory authorities and are steadily gaining in importance in the risk management processes of banks. Many banks have already started integrating these risks into their business models, but in doing so, are faced with issues in terms of disclosure and reporting to the relevant authorities, whose requirements have become more strict and more precise.

In one of our previous blogs we introduced the 2020 supervisory expectations regarding climate and environmental risks for banks, together with the self-assessment conducted by Dutch banks. So what is the current state of affairs? Were the banks able to implement these expectations into their risk management? In 2022, the ECB and DNB are carrying out thematic reviews. To accompany this process and to provide insights for the participating banks, we performed a new survey on the progress made by banks. 

It has become clear that, just as last year, climate-related risk still has the highest priority of all ESG related risks. However, it is noticeable that Dutch banks, irrespective of size, are prioritizing the other ESG risks – environmental (e.g. biodiversity), social and governance risks – significantly higher than other European Significant Institutions. This may be due to the relatively long-standing stakeholder pressure in the Netherlands compared to other countries, whereas it might also be explained by a higher intrinsic motivation of banks.

Our survey shows, firstly, that banks are taking significant steps towards full alignment with the expectations. In addition, banks indicate that most progress towards full alignment has been made in areas not heavily relying on data and quantitative risk measurement. Nonetheless substantial efforts have been undertaken in developing scenario analyses and stress testing. This year’s ECB Climate risk stress test may have acted as a driver.

One development which stands out is the increased perceived overall fulfilment of these expectations, which increased from 19% on average in 2021 to 51% in 2022. Most of the participating banks expect to be largely compliant (i.e., >80%) with the ECB expectations by 2025. At the moment, approximately 25% of the banks have achieved the desired level of fulfilment in a number of expectations. Materiality considerations play an important role in statements made on meeting the expectations, especially for market and liquidity risk.

At the moment, banks indicate the consideration of ESG risks in business goals is one of the most important, but also one of the most challenging expectations. The greatest potential for improvement regarding this consideration is currently in the areas of data acquisition, data management and the determination of KPIs. Qualitative targets are currently the most important means of integrating ESG issues into banks’ risk strategies. Banks that deal quantitatively with ESG issues, use mostly exposure analyses and portfolio alignment assessments for this purpose.

ESG topics are generally viewed as risk drivers rather than as a separate type of risk. ESG risks are therefore mainly quantified by implementing them into existing risk types, either as part of stress tests or by integrating them into existing models.

Credit risk is traditionally the most important risk for banks and hence there is a natural focus on integrating ESG risks into credit risk management. It is the only risk type in which all participating banks have – in some form or another – started to quantify ESG risks. The collection of the necessary data is a central challenge. The main sources for this are third-party commercial data providers, internal counterparty-level data, and external customer data from publicly available sources.

The majority of banks plan to integrate ESG risks into all stages of the credit risk management process, yet ESG risks have been included, so far, in only five out of ten stages by nearly 40% of participating institutions. As stages depend more on risk quantification, the lower the number of banks already able to include ESG risks. The stages with the lowest integration, are the early warnings framework and credit risk models used for regulatory purposes. 

We see supervisors increasingly pointing to climate-related reputational and litigation risks as a growing source of risk. The NGFS indicated there is a trend of more climate-related cases being filed around the world in recent years, in particular following the adoption of the Paris Agreement in 2015. The cumulative number of climate-related cases has more than doubled since 2015. Our survey reveals that there is potential for banks in improving their risk management processes. Just 22% of the banks assess controversies from external stakeholders other than clients on reputational and litigation risks. This percentage is higher for assessments covering clients, but nonetheless 45% indicated that they have not yet integrated ESG risk considerations in these assessments. On a positive note, the Dutch participants seem to be ahead of other European banks.

The strong advances in stress testing are also visible in the overall progress made in relation to the expectations as expressed in the KPMG survey on scenario analysis and stress testing. Only a handful banks bank indicated in 2021 any progress made on scenario analysis and stress testing; the 2022 results show that, on average, banks made significant steps and perceive themselves to be meeting supervisory expectations for, on average, 50%. Last year’s announcement of the ECB of the 2022 Climate risk stress test has likely acted as a catalysator. Banks needed to be well prepared for this stress test and have increased their efforts.

Even though significant progress has been made, the banks participating in the KPMG survey are aware that a considerable number of steps still need to be taken in order to include ESG risk drivers in all parts of their risk management. They are aware that it remains important to be flexible and to accept uncertainties and prepare for a journey where the route is not entirely fixed. This is, in essence, ultimately a leap of faith.