Capitalizing for Environmental and Social risks; EBA recommends enhancements to rules

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.

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). 

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.

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.

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.

As alluded to earlier, the EBA also recognizes key challenges faced by banks when assessing the impacts of E&S risks and their integration into regulatory metrics. Some of these key issues are: 

1. Data availability and measurement – challenges exist both for banks in identifying the risks for counterparties, as well as for supervisors in assessing and mapping E&S risks across banks.
2. Estimation of losses due to E&S risks – the prudential framework is calibrated on the basis of historical data, which does not fully reflect E&S risks as these are more forward-looking in nature. Banks need to increase their efforts to properly map financial losses to respective climate-related and other E&S risk events. To estimate the contribution of potential future financial impacts driven by physical events, the use of data based on scientific evidence about climate change, biodiversity loss and broader environmental degradation needs to be considered.
3. Time horizon considerations – a challenge exists in the potential mismatch between the time horizon of the Pillar 1 framework and the long-term time horizon over which environmental risks are likely to fully materialize.

Assessing the financial impacts arising from social risks poses challenges, due to a lack of relevant and granular data. Additionally, challenges arise in understanding the transmission channels through which these risks impact traditional financial risk types. Consequently, the EBA has indicated that incorporating social risks into the Pillar 1 framework would be premature at this point. Nonetheless, banks are encouraged to pursue efforts in identifying and incorporating the effects of social risks on their credit portfolios. 

The suggested recommendations, along with their associated implementation challenges, indicate that integrating E&S risks into the prudential framework will certainly play a part in reducing the likelihood of underestimating the potential credit risks associated with these factors. It is crucial for banks to take note of these recommendations and work towards a more comprehensive integration of E&S risks into their risk management frameworks. Thereby the recommendations should be read in conjunction with plans to meet ECB expectations and integration of E&S risks in credit risk models used for purposes other than Pillar 1 capital such as IFRS9 and loan pricing.