EBA Updates Pillar 1 to Include ESG Risks

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by KnowESG
KnowESG_EBA Updates Pillar 1 to Include ESG Risks
Image courtesy of Sean Gallup/Getty Images

The European Banking Authority (EBA) has just unveiled a groundbreaking report addressing the incorporation of environmental and social risks into the prudential framework for credit institutions and investment firms.

Employing a risk-focused perspective, the report evaluates the current prudential framework's ability to encompass environmental and social risks and offers targeted recommendations for bolstering their integration within Pillar 1.

These proposed enhancements are designed to expedite the transition toward a more sustainable economy while upholding the banking sector's resilience.

It's crucial to recognise that environmental and social risks are reshaping the risk landscape for the banking industry and are expected to assume even greater significance in the future. They extend their influence into traditional financial risk categories like credit, market, and operational risks. As a result, environmental and social factors have the potential to impact both individual institutions' risk profiles and the overall financial stability of the entire system.

In its report, the EBA advocates for risk-based refinements to the risk categories within the Pillar 1 framework. Furthermore, the report explores the potential application of macroprudential tools while also explaining the EBA's reservations regarding the introduction of green supporting factors or brown penalising factors at this juncture. The use of such adjustment factors is beset by complexities related to design, calibration, and intricate interactions with the existing Pillar 1 framework.

In light of these considerations, the EBA sets forth recommendations for immediate actions to be undertaken over the next three years as part of the implementation of the revised Capital Requirements Regulation and Capital Requirements Directive (CRR3/CRD6). Specifically, the EBA is proposing:

  • Incorporating environmental risks into stress testing programmes under both the internal ratings-based (IRB) and the internal model approaches (IMA) pursuant to the Fundamental Review of the Trading Book (FRTB).

  • Encouraging the inclusion of environmental and social factors in external credit assessments conducted by Credit Rating Agencies.

  • Promoting the incorporation of environmental and social factors into due diligence requirements and the valuation of immovable property collateral.

  • Mandating institutions to identify whether environmental and social factors could trigger operational risk losses.

  • Gradually developing metrics related to environmental concentration risk as part of supervisory reporting.

Taking a more long-term perspective, the report also introduces potential revisions to the Pillar 1 framework that acknowledge the growing significance of environmental and social risks. These prospective changes encompass:

  • The potential use of scenario analysis to enhance the forward-looking elements of the prudential framework.

  • The role that transition plans might play in future risk-based enhancements to the Pillar 1 framework.

  • A reconsideration of the appropriateness of revising the IRB supervisory formula and the corresponding standardised approach (SA) for credit risk to better incorporate environmental risk components.

  • The introduction of metrics related to environmental concentration risk within the Pillar 1 framework.

In parallel with other policy initiatives outside the prudential framework, the EBA is committed to further integrating environmental and social risks across all facets of the regulatory framework. This multifaceted approach underscores the agency's commitment to addressing the evolving financial landscape sustainably and responsibly.

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Source: EBA

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