Banks in Europe get world's first ESG add-on to capital rules

In a global first, Europe's main bank regulator is revising the framework that sets capital requirements so that lenders reflect environmental and social risks in mandatory, industrywide buffers.

The European Banking Authority has identified "some short-term fixes" to minimum requirements — known as Pillar 1 — "that can already be implemented," Chairman Jose Manuel Campa said in an interview. Others will be phased in over time, with some requiring new legislation, the EBA said.

The new requirements, outlined in a report published by the EBA on Thursday, mark the first in what's set to be a continuous reworking of the capital framework within which European banks must operate. The goal is to reflect the increasing threat to financial stability that regulators now see from ESG factors such as climate change and inequality.

ESG is "changing the risk profile for the banking sector," according to the EBA. The development is expected to become more pronounced over time and has implications for "traditional categories of financial risks, such as credit, market and operational risks," it said.

Until now, regulatory focus has largely been on disclosure and individual bank risk (known as Pillar 2), due in large part to a lack of adequate data and methodologies for calculating sector-wide ESG risks. 

The bank industry, meanwhile, has been emphatic in its opposition to such far-reaching capital requirements. 

In response to an EBA consultation last year, the European Banking Federation said it's against using Pillar 1 to address climate risks, arguing that capital assessments should allow for differences in bank balance sheets. Predicting losses also means relying on scenarios which are uncertain and shouldn't be used to set capital levels, the industry group said.

The EU's largest bank, BNP Paribas, warned separately that increasing capital requirements would hamper lenders' ability to provide transition finance, without necessarily making the industry any more resilient.

Banks with sector emission targets

The EBA's Campa said the new ESG requirements are "very concrete." But they won't have the same impact on capital ratios as the so-called Basel III rules that followed the financial crisis of 2008, he said. 

For now, the new ESG buffer rules aren't "going to lead to a significant, discrete increase in the short term," Campa said.

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That's in part because models for estimating the fallout of climate change, environmental degradation and inequality are in their infancy, compared with conventional risk management tools that have been built on historical data.

"There are a lot of areas that we need to understand better," Campa said. "One thing that is interesting that we capture in this report — and it's important for people to realize — is that as you think about regulation, we need to think differently about the methods that we have to assess this risk."

The EBA report contains more than five pages of instructions to banks and national supervisors for short and longer-term changes. That includes plans for future regulatory action, which the EBA says may require new legislation. Banks and national regulators will be expected to:
- Reevaluate collateral values to incorporate both physical and transition risks, and continue monitoring these values over the life of the exposure.
- Incorporate environmental risks into trading book risk budgets, internal trading limits and the creation of new products.
- Ensure external credit assessments integrate environmental and social factors as "drivers of credit risk."
- Adapt internal models for calculating risks from specific exposures to incorporate environmental and social factors and limit use of so-called overrides.
- Adjust probabilities of default and loss given defaults.
The EBA said it will continue work on a number of issues, including recommendations for banks with high degrees of exposure to particularly vulnerable industries including fossil fuel and real estate.Banks are highly likely to face bigger losses as the economy moves toward net zero emissions, though how big will depend on policies adopted to address climate change, according to a September report by the European Central Bank. Credit risk would more than double by 2030 in a so-called late push scenario compared with an increase of 60% in an accelerated transition, the ECB said.

The changes the EBA is making are part of a larger reconfiguration of banks' capital framework, which includes more extensive disclosure requirements around ESG. It's the latest demonstration of the EU's willingness to take a global lead in responding to the risks posed by climate change. 

Campa said banks and regulators need to adjust their approach. 

"We need to be forward-looking and we need to accept that we have to be forward looking. So we need to be willing to work more with scenarios," Campa said. "Climate is likely to increase the correlations among those risks that before you thought were diversified. Some you thought were not correlated, they're going to be very correlated."