As evidence suggests, environmental and social issues can impact borrowers' creditworthiness. Therefore, neglecting these risks can lead to an underestimation of credit risk through increased default probabilities and lower collateral valuations, especially in areas and sectors more prone to facing these issues.
The European Banking Authority (EBA), recognizing the potential impact of Environmental and Social (E&S) risks, has released a report advocating for the integration of E&S risk considerations into the Pillar 1 prudential framework applicable to banks. The report explores the feasibility and appropriateness of various targeted enhancements to better reflect the importance of E&S risk drivers in the prudential framework. Simultaneously, the EBA acknowledges the diverse challenges faced by banks when assessing these risks. This recognition reflects the inherent difficulty of incorporating these risks into the prudential framework.
Furthermore, the report specifically focuses on those elements of the framework most susceptible to be impacted by environmental risk factors. The goal of the proposed recommendations is to help ensure that the banking sector is better equipped to support the transition towards a more sustainable economy, while maintaining the sector’s resilience. All in all, an opportune moment to explore some of the key recommendations – as listed below – and what potential implications they hold for banks in terms of credit risk management.
Enhance counterparty due diligence
The EBA recognizes that there is room to broaden the current due diligence requirements to explicitly include environmental aspects which would ensure that E&S risks are appropriately captured and reflected in the prudential framework (both through the Standardized and Internal Ratings Based approaches). This aligns with the Basel Committee on Banking Supervision's (BCBS) clarifications (FAQ1) and ECB expectations (ECB Guide on climate-related and environmental risks), which recommends banks to consider climate-related financial risks in counterparty due diligence. Banks would thus be expected to review their current counterparty due diligence frameworks to allow for the adequate collection of relevant and material environmental risk data. Due diligence assessments performed by banks are expected to further improve with more Environmental, Social and Governance (ESG) information becoming available and with continued regulatory developments (i.e. European Union Corporate Sustainability Reporting Directive (CSRD) and Pillar 3 disclosures on ESG risks).
Incorporate environmental risk impacts into immovable property collateral valuation
There is growing evidence indicating the impact of environmental factors on the market value of immovable properties. Collateral values impact the level of regulatory capital to be held, through its impact on a credit facility’s Loss Given Default (LGD). Thus, to support effective risk management, the EBA recommends banks to account for relevant environmental factors in the valuation of immovable property collateral. In particular, banks should consider adjusting the current market value of collateral when it does not sufficiently account for the relevant risks associated with environmental factors that could affect the property’s market value over the exposure’s duration. These considerations encompass climate-related transition risks, physical risks and other environmental risks. They should be applied during the origination, collateral re-valuation and monitoring stages throughout the exposure's lifetime.
Integrate E&S risks into the risk differentiation and quantification stages of credit risk modeling
As part of the Internal Ratings Based (IRB) approach, the EBA recommends that E&S risks should be considered in risk differentiation by including additional risk drivers in their risk differentiation models, with a focus on avoiding any substantial decrease in the overall performance of the rating system as a result of these additions. Furthermore, the EBA recommends that E&S should also be considered in risk quantification through, for example, margin of conservatism, downturn component and calibration segments. As a long-term recommendation, banks are advised to include E&S risks in their calculations of Probability of Default (PD) and LGD estimates as soon as information about the impact of E&S risks on defaults and loss rates becomes available.
Expand on existing stress testing frameworks
Banks that make use of the IRB approach in calculating their own capital requirements for credit risk, must establish robust stress testing procedures. They are obligated to conduct regular credit risk stress tests to evaluate the impact of particular conditions on their overall capital requirements for credit risk. Consistent with clarifications from the BCBS (FAQ 11), the EBA suggests that banks include E&S risks in their stress testing programs. This implies that banks should incorporate E&S risk drivers, especially physical and transition risks associated with climate change, into their stress test scenarios when assessing severe, but plausible recession scenarios.