The Next Steps to Green Banking – Managing ESG Risks in the Banking Industry

Many banks have very publicly responded to increased pressure from consumers to integrate Environmental Social and Governance (ESG) factors into their decision making and product ranges. However, banks’ internal ESG balance sheet risk management and assessment are significantly less developed. This area is under regulatory focus and the industry will see extensive changes in banks’ ESG risk management practices in the coming years.

ESG accounting and Pillar 3 disclosures

The EU Commission recently proposed the Corporate Sustainability Reporting Directive (the CSRD). This will enhance ESG accounting disclosure requirements for banks. Banks must also make more extensive ESG disclosures in their regulatory Pillar 3 statements from June 2022. These disclosure requirements will apply to all large credit institutions with securities traded on a regulated market of any EU member state, although their precise content is not yet final.

The European Banking Authority (EBA) was mandated to produce a report outlining the content of these ESG disclosures and to issue related guidance. The resulting EBA report on management and supervision of ESG risks was published in June 2021. It goes beyond reviewing the format of banks’ ESG disclosures under Pillar 3 (“public disclosure” pillar) and assesses the coverage of ESG risks in Pillar 2 (“supervisory review” pillar).

Regulatory approach to ESG under Pillar 2

The EBA report provides definitions of ESG risks and elaborates on the arrangements for credit institutions to identify, assess, and manage them. It also gives guidance on how ESG risks should be included in the supervisory review and evaluation process (SREP) by competent authorities. This EBA report will be a cornerstone of EU bank supervisory policy going forward. The EBA will base future guidance on ESG risk management for institutions and updates on SREP guidance to supervisors on its contents. The CBI takes a deferential approach to EBA guidelines so we can expect these to be mandatory for Irish banks.

Irish-headquartered significant institutions (SIs) are already subject to regulatory expectations established by the ECB in its 2020 guide on climate-related and environmental risks. The ECB also recommended that national supervisors should apply the 2020 guide in their supervision of less significant institutions (LSIs) in a proportionate manner. We can expect the CBI to embrace this recommendation enthusiastically, as it has already identified climate-change as a key focus. When announcing its participation in the green bond investment fund established by the Bank for International Settlements in May 2021, it noted that regulated entities can expect it to become increasingly intrusive in supervision of climate-change risks going forward.

But what will regulators expect?

Blackrock published a study in August 2021 for the EU Commission which explored the integration of ESG factors into banks’ risk management processes and into prudential supervision. Overall, the study found that integration of ESG factors within banks and supervisors’ practices is at an early stage and identified several obstacles to further progress.

Does “double materiality” make regulatory sense?

The Blackrock study found that most banks assess ESG risks through both financial materiality and the material impact of activities on environmental and social factors. This is known as “double materiality” and is a central concept of the CSRD. However, the study also found that many banks have inconsistent ESG risk definitions. It also found that few had developed detailed lists with mappings to sectors, geographies, and client segments to understand their relevance. Climate-related risks are often mapped to financial risk types whereas other risk types are typically mapped to reputational or strategic risk. Banks are unclear whether traditional risk types can ever fully capture risks from an environmental and social materiality perspective. This appears to call into question the whole concept of “double materiality” as a basis for a scientific approach to risk management.

The Blackrock study found considerable debate among supervisors on “double materiality”. Most supervisors acknowledged the importance of considering the environmental and social impact of banking activities, but some maintained that the focus of prudential supervision should remain on financial materiality. There are also differing views among supervisors on whether ESG risk should be viewed as a principal risk itself or as a driver of other risk types. It seems challenging, given this lack of consensus on fundamental approaches, to find comprehensive strategies in the short term to fully integrate ESG risk into the prudential supervisory framework.

Is there a place for ESG risks under Pillar 1?

Many supervisors do not consider Pillar 1 tools suited to address ESG risks. The primary reason is that robust quantitative evidence for a risk differential, eg for green vs. brown assets, is yet to be established. Conversely, NGOs argue that capital requirements must play a role in incentivising banks to redirect capital to sustainable sectors and investments. Supervisors are concerned that this would be policy-based and may have unintended consequences.

Quantitative indicators for the measurement of ESG risks have not yet been defined by most supervisors. At this point, supervisory ESG risk assessment remains focused on qualitative elements typically used to assess processes within a bank, like review of business model, governance, and strategy.

Conclusion

Irish banks can expect to see more intense supervisory engagement under Pillar 2 with the qualitative elements of their ESG risk management processes in the near term alongside the new mandatory Pillar 3 disclosure requirements. It is less clear how the global regulatory framework will eventually capture ESG risk assessment under Pillar 1. We think that the CBI is likely to await the outcome of work underway at global and EU level in this area, rather than seeking to “go it alone” by applying national Pillar 2 capital add-ons for ESG risk. However, the CBI is likely to be an enthusiastic and early adopter under Pillar 2 of the impending EBA and current ECB guidance on banks’ qualitative ESG risk management. Therefore, we recommend that Irish banks should consider reviewing their governance and risk management arrangements for ESG risks urgently to meet the CBI’s likely expectations in this area.

For more information, contact a member of our Financial Regulation team.

The content of this article is provided for information purposes only and does not constitute legal or other advice.