Credit Risk Models

The need to address GeoPolitical Risks (GPR), to manage Climate and Environmental Risks (CER), and to maintain prudent credit risk standards are all explicitly highlighted among the ECB’s supervisory priorities for 2026-2028. The ECB is enforcing its expectations for the management of CER and further developing its approach for the integration and management of GPR. Overall, the ECB is increasing its focus on assessing whether banks’ credit ratings, IFRS 9 provisioning, and capital plans appropriately include the risks. Banks are aware that:

• GPR: The ECB conducts a GPR reverse stress test in 2026, and has stressed the need for banks to manage geo-political and macro-financial risks. 
• CER: Despite the Omnibus package simplifying ESG disclosures, CER remains a supervisory focus that the ECB reviews in a business as usual manner. Furthermore, the ECB will publish an updated version of its good practices in 2026. 

Given this background, banks will benefit from monitoring supervisory expectations and comparing their own progress of integrating GPR and CER into credit risk models with that of their peers. 

Informal benchmarking and conversations with our clients suggest a range of practices for GPR and CER integration. This is especially true for GPR, which is more often applied through overlays than fully integrated into credit risk models. CER integration is more mature, but here too there are gaps and inconsistencies in areas like LGD treatment and nature-related risk. More specifically:

GPR is commonly applied to internal credit ratings via qualitative expert judgement in the form of rating overrides, rather than systematic modelling. The reliance on overlays makes good governance of rating assignment process critical to ensuring consistency in GPR assessments. Also, coverage is often quite different, with many institutions making limited progress in applying GPR to mid-size corporate or SME borrowers.

Overlays (or post-model adjustments) are used widely for IFRS 9 provisioning. This is a pragmatic solution to evolving risks, enabling prompt reaction to the materialisation of new risks and patchy data, but it pushes up governance requirements to maintain the transparency and justifiability of overlays.

GPR is a cross-cutting risk driver that can have an impact on banks’ traditional risk categories, including credit, market, liquidity, business model, governance and operational risks. Thus, the ECB would expect banks to appropriately identify novel and consistently calculate and apply overlays for different risk types and exposures, across affected portfolios and models.

Furthermore, the ECB’s reverse stress test will require banks to demonstrate quantifiable links between GPR scenarios and 300bp of CET1 depletion. In this context, banks should ensure that overlays are consistently and reliably calculated and supported by sound risk data aggregation and reporting capabilities, meeting the requirements of the relevant ECB Guide.

Integration of climate and environmental risks in internal credit ratings is more advanced than for geopolitical risks. This is also due to the fact that banks need to comply with the final EBA Guidelines on managing ESG risks.

Many banks reflect CER in PD ratings, not only with overrides but increasingly via embedded model treatment, and further improvements are planned. However, LGD approaches often lag behind. For credit rating assignments, banks typically use customer-level data for climate transition risks (e.g. current and target Green House Gas (GHG) emissions and energy efficiency) and physical risks (e.g. location of production and physical risk scores). Data gaps at the customer level are supplemented with proxies. More banks plan to expand their focus to nature-related data.

A number of large banks have made progress in integrating CER into IFRS 9 provisioning, with others planning to do so. Increasing effort is being placed on forward-looking scenario design, staging logic, and CER-informed macroeconomic analysis; data-driven overlays quantified within shadow runs are also being considered.

On capital planning, some banks view CER as a material risk and reflect it in economic capital buffers. Others are working to refine materiality assessments, and to comply with the EBA’s Guidelines on ESG scenario analysis which apply from 2027. The key challenge is not to produce scenarios, but to translate them into controlled, explainable model outcomes.

Finally, the Omnibus package simplifying corporate sustainability and due diligence reporting may make CER integration more difficult, given that some banks already use these disclosures in their ratings. The EBA has warned that permanent simplifications of CER reporting could drive up bilateral data requests and affect model risks.

Current events show that GPR and CER are not diminishing. Integrating them into credit models, provisioning, and capital planning is vital to financial resilience and comprehensive credit risk management. Furthermore, banks that fail to meet supervisory expectations risk stronger supervisory challenge, weaker model credibility, and greater pressure on governance and remediation - as well as penalties and reputational damage.

To prepare themselves for increased scrutiny of GPR and CER integration during 2026, banks should: