Response to discussion paper on the role of environmental risk in the prudential framework
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• Perfectly green banks can have unacceptable leverage and liquidity numbers, and vice-versa;
• Time horizons are different (like: LCR: 30days vs. climate risks: 30 years, although the materialization of physical climate risks is already observed);
• Adapting inflow rates to climate risks would not fit the purpose of liquidity, as inflow rates represent an estimation of (short term) payments, independent of any climate risks;
• in case an LCR per currency for countries subject to higher climate risks was established, this concept would disregard those currencies can be used outside of a country (e.g. USD is used outside USA).
Nonetheless, there could be periods where the pace and intensity with which some climate risk scenarios will unfold (e.g. technological unexpected transition, hard-hitting climate events), which could have macroeconomic impacts and determine an increase in the overall bank system risk exposures.
Banks seem to be preparing for risks arising from climate risk and other ESG risks:
• The banking industry is in the process of integrating ESG factors in their strategies, governance, risk appetite, risk and control management, in line with the ECB guide on climate-related and environmental risks and the CRD’s pillar 2 provisions on ESG.
• In terms of transition risks and physical risks, there is a consensus to not consider risks associated with climate change as a new risk category but rather an aggravating factor for those categories already covered by the Bank’s risk management system (credit risks, operational risks, reputational risks, insurance risks, etc.). Accordingly, existing frameworks and processes are being updated to integrate climate risk factors and ensure that their increasing importance is properly taken into account.
Calling climate risk a “risk” in the context of finance would be a fundamental mistake. Risk calculations are based on historical data. But potential outcomes of a climate disaster cannot be calculated, other than with scenarios, nor will we ever have data to estimate this risk. Climate risk as meant in the DP is more an “uncertainty”, as meant by Knight (1921). Uncertainties are more like “group risks”, compounding risks when more exposures are added, as opposed to the traditional credit, liquidity and market risks that banks take up and diversify. Think of contagion in a complex group, conflicts of interest, risk beliefs, cyber-risks, culture. And climate risk. Group risks materialize in a crisis, when the group is hit by a shock and vulnerabilities across the group are revealed.
Limiting compounding risk from risk concentration is addressed in the Basel framework in the Large Exposures (LEX) regime. The proper way to deal with uncertainties in banking is imposing limits, ringfencing vulnerable portfolios, and behavioural interventions (you can do this, but you cannot do that). Simply, reduce vulnerable exposures. The LEX regime imposes extra buffers in case a bank exposes itself to too much of something that seems good (like sectors, or business families, or regions), but may end up in more and more losses given contagion channels.
There’s no capital requirement that could be justified to acknowledge climate risk, other than full deduction, which may not even be enough. It’s limits and fences and behavioural rules that must decrease banks’ exposures to climate risk.
Compare to other exposures to groups of connected clients in the LEX-regime: these clients are assessed individually, resulting in an individual risk premium, and an add on is applied in case there are too many connected clients in the LEX regime.
Banks are facing significant challenges related to data due to the following reasons:
- Data protection national laws: In case of EPCs, this information is only available in some jurisdictions to i) the owner of the EPC or ii) a third party in case of having the owner's approval. That means even being available data, its use is not warranted.
- In addition to specific Pillar 3 data, financial entities could face difficulties in extracting ESG data (insufficient company disclosure, disclosure that may not be structured or easily gathered). This has been highlighted recently with the publication of reference information to the EU taxonomy (publication of eligible activities by EU companies subject to NFRD). Vendors / Data providers also may have the same difficulties
We would appreciate further guidance by the EU institutions regarding:
- Guidance on collateral valuations
- a standardised assessment of GHG emissions
- the development of proxies
Open-source initiatives to provide both reliable and normalized data could be promoted by governments and institutions, in order to open up time and resources for analytical work.
We would like to underline that to make sustainable decisions in finance, a financial institution is not bound by the availability of data. Choices and assessments of what is sustainable or not can already start with a qualitative assessment and with estimation methodologies like PCAF.
Please note that banks have a deep and comprehensive understanding of their customers’ specific situation and risk profile. Therefore, the risk-based approach should include sufficient flexibility for banks to exercise judgement and account for factors that mitigate risk. In this context, we strongly disagree with the statement in the DP on the Standardised Approach: “This approach aims at striking a balance between simplicity and risk sensitivity and it does not distinguish between potential differences in the creditworthiness of each individual borrower, otherwise than through external credit assessments, where these are available.” (par 66). As a responsible SA bank, we always assess individual exposures’ risk profiles:
• Differences are distinguished directly at the front office, e.g. by assessing the integrity and the goals of prospects prior to onboarding, by following (conservative) internal credit risk policies, by valuation of collateral and by entering credit risk mitigation clauses in the credit agreements.
• Also provisions are made, altogether with credit valuation adjustments that can/could be linked to ESG risks.
• New products are invented aligning with ESG risk mitigation, such as Triodos’ Biobased Mortgage.
• It is generally known that the standardised risk-weights for own funds requirements for credit risk are much higher under the SA than under the IRB approach. SA reserves are therefore relatively higher than IRB reserves. It seems illogic and contrary to the goals of green banks and EBA to increase these own funds requirements.
• The output floor as is mentioned in the Commission’s CRR3 proposal will be relevant for IRB banks, but this SA based floor will maximise approx. 72.5% of the capital requirements under IRB, whereas there is no such relief under the SA. Again, extended ESG incorporation in pillar 1 is not necessary for SA banks, other than through large exposure limits.
• It is very likely that environmental risks will be incorporated in external credit assessments, even on a voluntary basis due to the increased common sense of urgency. This way, ESG will automatically be incorporated in pillar 1, also under SA.
• The introduction of pillar 3 disclosures on ESG risks (market disclosure) will also contribute to ESG sensitivity, hence impacting in a natural way the business strategy and business operations.
• ESG risks are already being integrated into the risk management framework (pillar 2 capital buffers, ESG risks framework, SREP, ICAAP). Currently the own funds requirements are already increased by the upgrade of the countercyclical buffers.
Attempts to reconcile the two would imply errors and unintended consequences.
It is thus not feasible but neither desired to adjust the current time horizon of the prudential framework, and recalculate of PDs, LGDs, EADs, and ultimately capital requirements, as the different horizons reflect different kinds of materializing losses.
Instead, we would suggest exploring the possibilities which exist already in the current framework to incorporate risks with a longer time horizon: limits, fences and behavioural rules. Alternatively, the ECBS/EBA could think of a pillar 4 dealing with longer-term risk and impact of the financial system as a whole and the financial institutions in it.
• Differences are distinguished directly at the front office, e.g. by assessing the integrity and the goals of prospects prior to onboarding, by following (conservative) internal credit risk policies, by valuation of collateral and by entering credit risk mitigation clauses in the credit agreements.
• Also provisions are made, altogether with credit valuation adjustments that can/could be linked to ESG risks.
• New products are invented aligning with ESG risk mitigation, such as Triodos’ Biobased Mortgage.
• It is generally known that the standardised risk-weights for own funds requirements for credit risk are much higher under the SA than under the IRB approach. SA reserves are therefore relatively higher than IRB reserves. It seems illogic and contrary to the goals of green banks and EBA to increase these own funds requirements.
• The output floor as is mentioned in the Commission’s CRR3 proposal will be relevant for IRB banks, but this SA based floor will maximise approx. 72.5% of the capital requirements under IRB, whereas there is no such relief under the SA. Again, extended ESG incorporation in pillar 1 is not necessary for SA banks, other than through large exposure limits.
• It is very likely that environmental risks will be incorporated in external credit assessments, even on a voluntary basis due to the increased common sense of urgency. This way, ESG will automatically be incorporated in pillar 1, also under SA.
• The introduction of pillar 3 disclosures on ESG risks (market disclosure) will also contribute to ESG sensitivity, hence impacting in a natural way the business strategy and business operations.
• ESG risks are already being integrated into the risk management framework (pillar 2 capital buffers, ESG risks framework, SREP, ICAAP). Currently the own funds requirements are already increased by the upgrade of the countercyclical buffers.
Client due diligence is already adapting to the need to capture climate and environmental risk dimension. This reflects both internal risk management considerations as well as debt and equity investors’ increased awareness and sensitivity to this risk dimension.
The gradual increase in client C&E related disclosures (be it government mandated or voluntary) – and trend towards greater standardization and comparability of disclosed metrics / KPIs – is expected to increase the consistency of C&E risk assessments, and resulting insight gained through it.
In many cases, environmental data is not available by the client, central databases or external data provides. The regulatory and/or market standard for data requirements is fast developing. Especially, private clients do not have the knowledge nor the financial capacity to provided audited documentation on environmental risks (e.g. for their real estate). Additionally, to this, there are currently not enough experts in the market to cover all these data requests (e.g. proofing EPC by inspections or calculation of energy supply for solar panels).
Many data points have to be estimated on portfolio level based on national or regional averages. Beside the underlying model risk, this bears also reputational risk for a bank since optimistic deviation could also be addressed as greenwashing.
Another challenge currently relates to overlaps to existing requirements, e.g. value chain assessment in KYC.
- For Unfunded Credit Protection (UFCPs) environmental factors will be progressively incorporated by CRAs in credit ratings and so in the guarantor’s risk weight, which is reviewed by banks and possibly adjusted to further take into account those factors as part of their due diligence requirements
- For collateral (other than immovable property which is covered by a specific framework), we deem that current re-valuation requirements of EU prudential framework are sufficient to account for environmental factors.
- As data and methodologies improve over time, the reflection of environmental factors will be naturally enhanced in collateral valuation and, as discussed in the previously, via a strengthened due diligence.
Moreover, where energy certificates are required, further guidance would be welcome on
potential overlaps with existing national rules and guidance.
Limiting compounding risk from risk concentration is addressed in the Basel framework in the Large Exposures (LEX) regime, which is part of pillar 1. The proper way to deal with uncertainties in banking is imposing limits, ringfencing vulnerable portfolios, and behavioural interventions (you can do this, but you cannot do that). Simply, reduce vulnerable exposures. The LEX regime imposes extra buffers in case a bank exposes itself to too much of something that seems good (like sectors, or business families, or regions), but may end up in more and more losses given contagion channels.
We support the EBF’s suggestion to introduce a dedicated adjustment factor named Sustainability adjustment factor (SAF) for both 1) energy-efficient mortgages and 2) other suitable exposures. The aim is to steer capital flows toward sustainable economic activities and at the same time allocate credit to the less risky ones. This portfolio approach is however, by definition a Pillar 2 portfolio approach.
The first proposal aims to apply a sound treatment to mortgage credit in order to encourage lenders to grant these loans which can contribute to: (i) reducing the energy consumption and greenhouse gas emission; (ii) achieving the EU target for zero-emission building stock by 2050 contained in Commission Work Programme “Fit for 55” package. This preferential treatment in Pillar 2 would also encourage lenders to apply better conditions to mortgage loans, pushing the demand for this kind of credit. The proposal is also in line with the purpose of Energy Performance of Buildings Directive (EPBD).
The second one is less precisely defined because it is based on the idea of suitable exposures that need to be identified. Suitable exposures are related to cluster of taxonomy aligned exposures identified by EBA via sample-based forward-looking methodologies that are characterized by a reduced prospective financial risk. In this respect, a more precise mandate is needed for EBA to study other asset classes in view of an extension of the adjustment, based on evidence of reduced riskiness of exposures by virtue of their environmental sustainability.
Both proposals are temporary and risk based. Both are based on a mechanism similar to other supporting factors (to be applied after traditional RWA calculation, and therefore meant for both STA and IRB) and applicable only to well-identified exposures. By construction, SAF does not have double-counting issues because it can be applied only until banks will have validated models that integrate ESG factors or until the standard prudential framework will split sustainable and non-sustainable exposures.
Rather, the exposures in the trading book must be added to the relevant large exposures to harmful assets under the LEX regime.
Rather, the exposures in the trading book must be added to the relevant large exposures to harmful assets under the LEX regime.
Practical challenges relate to:
1. Identification taking into account certain info that is not routinely captured in the event logs, only in case the most relevant ones.
2. Lack of automatization when using data.
3. The use of operational risk taxonomies different from the regulatory existing ones may create overlaps or confusion, including the development of banks’ internal systems
4. Quantification, as access to climate data and forecast possibilities are limited
5. The identification of the right kind of information that helps to capture the operational risk losses due to environmental factors (including the development of potential proxies, considering that there is not yet established historical information)
6. Collecting information at subsidiary level to capture operational risk losses that can be used for meaningful comparisons, because the work being performed on sustainability is not always comparable across countries or developed at the same pace, and this could hamper the comparability of the information collected.
Nevertheless, guidance is expected to prevent the development of an unlevel playing field. It is important when developing these guidelines, the EBA should take into account that given that supervisory exercises are already ongoing, the flexibility regulators and supervisors are providing in terms of methodologies needs to be maintained over time given the large-scale investments that banks are undertaking to develop methodologies and internal systems.
Moreover, from the relevant section of the discussion paper we understand that the potential thrust of such concentration risks is not limited to a high risk of natural catastrophes like flooding, earthquakes or wildfire, but could also potentially include steering of exposure concentrations to environmentally harmful sectors, like the mentioned carbon-intensive industries. This is why integrating climate risk exposures in the LEX regime is justified. Regulation should shield banks from getting involved in new potential stranded assets, and it should steer their efforts to guide clients into the transition, and as such prevent materializing financial risk on a >10 year horizon.
The LEX regime of the Basel framework already provides banks with ample opportunity to limit disproportionately large losses that could arise in the event of counterparty failure due the occurrence of unforeseen events.
Second, climate “risk” is a compounding risk, aggravating potential losses when more exposures are added, as opposed to the traditional credit, liquidity and market risks that banks can diversify. It is very difficult to follow movements of climate risk and find a pattern that may make outcomes predictable with assigned probabilities. Rather, compounding risks are identified when stress testing a normal situation against extreme situations. Or worse, group risks materialize in a crisis, when the group is hit by a shock and vulnerabilities across the group are revealed.
The proper way to deal with uncertainties in banking is to impose limits, ring fence vulnerable portfolios, and introduce behavioral interventions (you can do this, but you cannot do that). Simply put, reduce vulnerability exposures. The LEX regime imposes additional buffers in case a bank exposes itself to too much of something that seems good (e.g., sectors, business families, or regions), thereby increasing the risk of incurring large losses due to contagion.
There is no capital requirement for addressing climate risk other than full deduction, which may not even be enough. It is therefore pointless to try to find data for estimating climate-related risks. The only way that banks’ exposure to climate risk can be decreased is through setting large exposure limits, based on financed emissions paths that reflect the IPCC scenarios as well as on existing legislation that announces which assets (like cars, or deforestation) are phasing out.
Q1: In your view, how could exposures associated with social objectives and/or subject to social impacts, which are outside the scope of this DP, be considered in the prudential framework? Please provide available evidence and methodologies which could inform further assessment in that regard.
To adhere to our mission of making money work for positive change, while generating a balanced return, Triodos Bank separates two sustainability impact lenses: 1) Inside Out perspective: the impact of our organisation and investments on the sustainability factors as in the outside world, resulting in positive or negative impact, 2) Outside In perspective: the impact of sustainability factors as in the outside world on our organisation and investments, resulting in sustainability risks such as physical/societal and transition risks. Social impact and risks are always context driven, and should be assessed as such. Social and governance issues are reflected in the economic and political risks of a country and therefore, country risks can be an indicator for societal risks. The social taxonomy of the EU can also give an indication of the social transition risks of a company and for which extra risk weights could be given.Q2: Do you agree with the EBA’s assessment that liquidity and leverage ratios will not be significantly affected by environmental risks? If not, how should these parts of the framework be included in the analysis?
We agree that liquidity and leverage ratios are the wrong instruments for capturing climate risks because• Perfectly green banks can have unacceptable leverage and liquidity numbers, and vice-versa;
• Time horizons are different (like: LCR: 30days vs. climate risks: 30 years, although the materialization of physical climate risks is already observed);
• Adapting inflow rates to climate risks would not fit the purpose of liquidity, as inflow rates represent an estimation of (short term) payments, independent of any climate risks;
• in case an LCR per currency for countries subject to higher climate risks was established, this concept would disregard those currencies can be used outside of a country (e.g. USD is used outside USA).
Q3: In your view, are environmental risks likely to be predominantly about reallocation of risk between sectors, or does it imply an increase in overall risk to the system as a whole? What are the implications for optimum levels of bank capital?
In our view and in a long-term perspective, environmental risks are likely to be predominantly about of reallocation of risk between sectors (and, within the same sector, between first-class versus laggard counterparties) because this class of risk will be introduced into the risk appetite policies. Our view is that there will be policies on the reduction of exposures to companies operating in the sectors most affected by the transition and that do not put in place (or do have no technological solutions to put in place) risk mitigation strategies. So banks which do not adopt this strategy would be more exposed to the environmentally-related risk factors. Symmetrically there could be an increase of exposure to economic activities that are less affected or are in a better competitive position due to their positive environmental impact profiles.Nonetheless, there could be periods where the pace and intensity with which some climate risk scenarios will unfold (e.g. technological unexpected transition, hard-hitting climate events), which could have macroeconomic impacts and determine an increase in the overall bank system risk exposures.
Banks seem to be preparing for risks arising from climate risk and other ESG risks:
• The banking industry is in the process of integrating ESG factors in their strategies, governance, risk appetite, risk and control management, in line with the ECB guide on climate-related and environmental risks and the CRD’s pillar 2 provisions on ESG.
• In terms of transition risks and physical risks, there is a consensus to not consider risks associated with climate change as a new risk category but rather an aggravating factor for those categories already covered by the Bank’s risk management system (credit risks, operational risks, reputational risks, insurance risks, etc.). Accordingly, existing frameworks and processes are being updated to integrate climate risk factors and ensure that their increasing importance is properly taken into account.
Calling climate risk a “risk” in the context of finance would be a fundamental mistake. Risk calculations are based on historical data. But potential outcomes of a climate disaster cannot be calculated, other than with scenarios, nor will we ever have data to estimate this risk. Climate risk as meant in the DP is more an “uncertainty”, as meant by Knight (1921). Uncertainties are more like “group risks”, compounding risks when more exposures are added, as opposed to the traditional credit, liquidity and market risks that banks take up and diversify. Think of contagion in a complex group, conflicts of interest, risk beliefs, cyber-risks, culture. And climate risk. Group risks materialize in a crisis, when the group is hit by a shock and vulnerabilities across the group are revealed.
Limiting compounding risk from risk concentration is addressed in the Basel framework in the Large Exposures (LEX) regime. The proper way to deal with uncertainties in banking is imposing limits, ringfencing vulnerable portfolios, and behavioural interventions (you can do this, but you cannot do that). Simply, reduce vulnerable exposures. The LEX regime imposes extra buffers in case a bank exposes itself to too much of something that seems good (like sectors, or business families, or regions), but may end up in more and more losses given contagion channels.
There’s no capital requirement that could be justified to acknowledge climate risk, other than full deduction, which may not even be enough. It’s limits and fences and behavioural rules that must decrease banks’ exposures to climate risk.
Q4: Should the ‘double materiality’ concept be incorporated within the prudential framework? If so, how could it be addressed?
Of course, double materiality should be applied in bank finance, as it is by any other corporate subject to CSRD. The potential negative feedback loop caused by a climate emergency calls for monitoring and managing of both financial implications (outside in) and environmental implications of finance (inside out). For example, financed emissions will make the economy more vulnerable and thus imply a risk to the system and the banks part of it, as extensively explained by the IPCC. Banks should thus be obliged to limit their financed emissions as much as possible, for example with large exposure limits (inside out) as well as apply risk premia to vulnerable exposures (outside in).Compare to other exposures to groups of connected clients in the LEX-regime: these clients are assessed individually, resulting in an individual risk premium, and an add on is applied in case there are too many connected clients in the LEX regime.
Q5: How can availability of meaningful and comparable data be improved? What specific actions are you planning or would you suggest to achieve this improvement?
From a banking system point of view, specific activities by single banks (engagement) should act as refinements on a sound and robust data layer that should be built through Pillar3, ESAP, and CSRD and also by way of standard simplified templates for SMEs. We would also encourage EBA, ECB, JRC and other institutions to produce proxies to be used by banks as an option at least for some years, because building meaningful and comparable datasets will take time. In any case, it would be important to build on data that is already available through some providers. This is important, as banks may go beyond the information disclosed through Pillar 3 and CSRD, if other type of information could be used to support the modelling of risks.Banks are facing significant challenges related to data due to the following reasons:
- Data protection national laws: In case of EPCs, this information is only available in some jurisdictions to i) the owner of the EPC or ii) a third party in case of having the owner's approval. That means even being available data, its use is not warranted.
- In addition to specific Pillar 3 data, financial entities could face difficulties in extracting ESG data (insufficient company disclosure, disclosure that may not be structured or easily gathered). This has been highlighted recently with the publication of reference information to the EU taxonomy (publication of eligible activities by EU companies subject to NFRD). Vendors / Data providers also may have the same difficulties
We would appreciate further guidance by the EU institutions regarding:
- Guidance on collateral valuations
- a standardised assessment of GHG emissions
- the development of proxies
Open-source initiatives to provide both reliable and normalized data could be promoted by governments and institutions, in order to open up time and resources for analytical work.
We would like to underline that to make sustainable decisions in finance, a financial institution is not bound by the availability of data. Choices and assessments of what is sustainable or not can already start with a qualitative assessment and with estimation methodologies like PCAF.
Q6: Do you agree with the risk-based approach adopted by the EBA for assessing the prudential treatment of exposures associated with environmental objectives / subject to environmental impacts? Please provide a rationale for your view.
We overall agree with the risk-based approach adopted by the EBA for assessing the prudential treatment of exposures associated with environmental objectives / subject to environmental impacts. This of course also means that the taxonomy has its limits for the prudential treatment considering that the taxonomy was not intended as a risk management framework.Please note that banks have a deep and comprehensive understanding of their customers’ specific situation and risk profile. Therefore, the risk-based approach should include sufficient flexibility for banks to exercise judgement and account for factors that mitigate risk. In this context, we strongly disagree with the statement in the DP on the Standardised Approach: “This approach aims at striking a balance between simplicity and risk sensitivity and it does not distinguish between potential differences in the creditworthiness of each individual borrower, otherwise than through external credit assessments, where these are available.” (par 66). As a responsible SA bank, we always assess individual exposures’ risk profiles:
• Differences are distinguished directly at the front office, e.g. by assessing the integrity and the goals of prospects prior to onboarding, by following (conservative) internal credit risk policies, by valuation of collateral and by entering credit risk mitigation clauses in the credit agreements.
• Also provisions are made, altogether with credit valuation adjustments that can/could be linked to ESG risks.
• New products are invented aligning with ESG risk mitigation, such as Triodos’ Biobased Mortgage.
• It is generally known that the standardised risk-weights for own funds requirements for credit risk are much higher under the SA than under the IRB approach. SA reserves are therefore relatively higher than IRB reserves. It seems illogic and contrary to the goals of green banks and EBA to increase these own funds requirements.
• The output floor as is mentioned in the Commission’s CRR3 proposal will be relevant for IRB banks, but this SA based floor will maximise approx. 72.5% of the capital requirements under IRB, whereas there is no such relief under the SA. Again, extended ESG incorporation in pillar 1 is not necessary for SA banks, other than through large exposure limits.
• It is very likely that environmental risks will be incorporated in external credit assessments, even on a voluntary basis due to the increased common sense of urgency. This way, ESG will automatically be incorporated in pillar 1, also under SA.
• The introduction of pillar 3 disclosures on ESG risks (market disclosure) will also contribute to ESG sensitivity, hence impacting in a natural way the business strategy and business operations.
• ESG risks are already being integrated into the risk management framework (pillar 2 capital buffers, ESG risks framework, SREP, ICAAP). Currently the own funds requirements are already increased by the upgrade of the countercyclical buffers.
Q7: What is your view on the appropriate time horizon (s) to be reflected in the Pillar 1 own funds requirements?
While the general Time Horizon(s) for the quantification of the Pillar I risk is one year for good reasons (as agreed in 1988 with Basel I, depositors should always be able to withdraw their savings within one year), integrating climate risk into this one year doesn’t make sense, as the general idea of materializing climate risk is associated with a horizon 20-30 years.Attempts to reconcile the two would imply errors and unintended consequences.
It is thus not feasible but neither desired to adjust the current time horizon of the prudential framework, and recalculate of PDs, LGDs, EADs, and ultimately capital requirements, as the different horizons reflect different kinds of materializing losses.
Instead, we would suggest exploring the possibilities which exist already in the current framework to incorporate risks with a longer time horizon: limits, fences and behavioural rules. Alternatively, the ECBS/EBA could think of a pillar 4 dealing with longer-term risk and impact of the financial system as a whole and the financial institutions in it.
Q8: Do you have concrete suggestions on how the forwardlooking nature of environmental risks could be reflected across the risk categories in the Pillar 1 framework?
Following the Paris Climate Agreement and the subsequent commitments by countries and their financial sectors, banks can be corrected for deviating from the path to zero in 2050. Financed emissions this year must thus always be lower than last year, and preferably lower than the target set against this zero emissions goal. A capital charge should apply for the emissions higher than last year, or higher than the target that can reasonably be expected given the zero in 2050Q9: Have you performed any further studies or are you already using any specific ESG dimensions to differentiate within credit risk? If so, would you be willing to share your results?
We strongly disagree with the statement in the DP on the Standardised Approach: “This approach aims at striking a balance between simplicity and risk sensitivity and it does not distinguish between potential differences in the creditworthiness of each individual borrower, otherwise than through external credit assessments, where these are available.” (par 66). As a responsible SA bank, we always assess individual exposures’ risk profiles:• Differences are distinguished directly at the front office, e.g. by assessing the integrity and the goals of prospects prior to onboarding, by following (conservative) internal credit risk policies, by valuation of collateral and by entering credit risk mitigation clauses in the credit agreements.
• Also provisions are made, altogether with credit valuation adjustments that can/could be linked to ESG risks.
• New products are invented aligning with ESG risk mitigation, such as Triodos’ Biobased Mortgage.
• It is generally known that the standardised risk-weights for own funds requirements for credit risk are much higher under the SA than under the IRB approach. SA reserves are therefore relatively higher than IRB reserves. It seems illogic and contrary to the goals of green banks and EBA to increase these own funds requirements.
• The output floor as is mentioned in the Commission’s CRR3 proposal will be relevant for IRB banks, but this SA based floor will maximise approx. 72.5% of the capital requirements under IRB, whereas there is no such relief under the SA. Again, extended ESG incorporation in pillar 1 is not necessary for SA banks, other than through large exposure limits.
• It is very likely that environmental risks will be incorporated in external credit assessments, even on a voluntary basis due to the increased common sense of urgency. This way, ESG will automatically be incorporated in pillar 1, also under SA.
• The introduction of pillar 3 disclosures on ESG risks (market disclosure) will also contribute to ESG sensitivity, hence impacting in a natural way the business strategy and business operations.
• ESG risks are already being integrated into the risk management framework (pillar 2 capital buffers, ESG risks framework, SREP, ICAAP). Currently the own funds requirements are already increased by the upgrade of the countercyclical buffers.
Q11: Do you see any challenge in broadening due diligence requirements to explicitly integrate environmental risks?
We underline that due diligence is more than collecting data. Triodos Bank stands for knowing its customers and knowing the positive and negative impact of the activity. There are multiple challenges in assessing environmental risks quantitively, but we would like to underline that to make sustainable decisions or assessing risks in finance, a financial institution is not bound by the availability of data. Choices and assessments of what is sustainable or not can already start with a qualitative assessment and with estimation methodologies like PCAF.Client due diligence is already adapting to the need to capture climate and environmental risk dimension. This reflects both internal risk management considerations as well as debt and equity investors’ increased awareness and sensitivity to this risk dimension.
The gradual increase in client C&E related disclosures (be it government mandated or voluntary) – and trend towards greater standardization and comparability of disclosed metrics / KPIs – is expected to increase the consistency of C&E risk assessments, and resulting insight gained through it.
In many cases, environmental data is not available by the client, central databases or external data provides. The regulatory and/or market standard for data requirements is fast developing. Especially, private clients do not have the knowledge nor the financial capacity to provided audited documentation on environmental risks (e.g. for their real estate). Additionally, to this, there are currently not enough experts in the market to cover all these data requests (e.g. proofing EPC by inspections or calculation of energy supply for solar panels).
Many data points have to be estimated on portfolio level based on national or regional averages. Beside the underlying model risk, this bears also reputational risk for a bank since optimistic deviation could also be addressed as greenwashing.
Another challenge currently relates to overlaps to existing requirements, e.g. value chain assessment in KYC.
Q12: Do you see any specific aspects of the CRM framework that may warrant a revision to further account for environmental risks?
We believe that the current CRM framework does not need modifications to further account for environmental factors, whether with a positive or negative impact.- For Unfunded Credit Protection (UFCPs) environmental factors will be progressively incorporated by CRAs in credit ratings and so in the guarantor’s risk weight, which is reviewed by banks and possibly adjusted to further take into account those factors as part of their due diligence requirements
- For collateral (other than immovable property which is covered by a specific framework), we deem that current re-valuation requirements of EU prudential framework are sufficient to account for environmental factors.
- As data and methodologies improve over time, the reflection of environmental factors will be naturally enhanced in collateral valuation and, as discussed in the previously, via a strengthened due diligence.
Q13: Does the CRR3 proposal’s clarification on energy efficiency improvements bring enough risk sensitiveness to the framework for exposures secured by immovable properties? Should further granularity of risk weights be introduced, considering energy-efficient mortgages? Please substantiate your view.
Due to EU Taxonomy, energy efficiency has to be proven by EPC documentation. For EPCs, there is a data gap as well as lack of experts to provide sufficient documentation for the already booked transactions on the balance sheet. For data availability, a central European governmental initiative is needed to collect standardized data (at least within Europe).Moreover, where energy certificates are required, further guidance would be welcome on
potential overlaps with existing national rules and guidance.
Q16: Do you have any other proposals on integrating environmental risks within the SA framework?
In light of the finalisation of Basel III, environmental risks (mitigation) should be incorporated, for example energy efficiency and material passporting.Q20: What are your views on potential strengthening of the environmental criterion for the infrastructure supporting factor? How could this criterion be strengthened?
some noise as not all the banks are interpreting it in the same way. Further guidance should be provided for banks to use homogeneous criteria. In fact, in the rapporteur report on the transposition of Basel III, the environmental criterion is modified to fulfil at least 1 of the environmental objectives, which makes more sense, as going forward, only positive impact ventures should be allowed.Q21: What would in your view be the most appropriate from a prudential perspective: aiming at integrating environmental risks into existing Pillar 1 instruments, or a dedicated adjustment factor for one, several or across exposure classes? Please elaborate.
There’s no capital requirement that could be justified to acknowledge climate risk, other than full deduction, which may not even be enough. It’s limits and fences and behavioural rules that must decrease banks’ exposures to climate risk.Limiting compounding risk from risk concentration is addressed in the Basel framework in the Large Exposures (LEX) regime, which is part of pillar 1. The proper way to deal with uncertainties in banking is imposing limits, ringfencing vulnerable portfolios, and behavioural interventions (you can do this, but you cannot do that). Simply, reduce vulnerable exposures. The LEX regime imposes extra buffers in case a bank exposes itself to too much of something that seems good (like sectors, or business families, or regions), but may end up in more and more losses given contagion channels.
We support the EBF’s suggestion to introduce a dedicated adjustment factor named Sustainability adjustment factor (SAF) for both 1) energy-efficient mortgages and 2) other suitable exposures. The aim is to steer capital flows toward sustainable economic activities and at the same time allocate credit to the less risky ones. This portfolio approach is however, by definition a Pillar 2 portfolio approach.
The first proposal aims to apply a sound treatment to mortgage credit in order to encourage lenders to grant these loans which can contribute to: (i) reducing the energy consumption and greenhouse gas emission; (ii) achieving the EU target for zero-emission building stock by 2050 contained in Commission Work Programme “Fit for 55” package. This preferential treatment in Pillar 2 would also encourage lenders to apply better conditions to mortgage loans, pushing the demand for this kind of credit. The proposal is also in line with the purpose of Energy Performance of Buildings Directive (EPBD).
The second one is less precisely defined because it is based on the idea of suitable exposures that need to be identified. Suitable exposures are related to cluster of taxonomy aligned exposures identified by EBA via sample-based forward-looking methodologies that are characterized by a reduced prospective financial risk. In this respect, a more precise mandate is needed for EBA to study other asset classes in view of an extension of the adjustment, based on evidence of reduced riskiness of exposures by virtue of their environmental sustainability.
Both proposals are temporary and risk based. Both are based on a mechanism similar to other supporting factors (to be applied after traditional RWA calculation, and therefore meant for both STA and IRB) and applicable only to well-identified exposures. By construction, SAF does not have double-counting issues because it can be applied only until banks will have validated models that integrate ESG factors or until the standard prudential framework will split sustainable and non-sustainable exposures.
Q23: What are your views on possible approaches to incorporating environmental risks into the FRTB Standardised Approach? In particular, what are your views with respect to the various options presented: increase of the risk-weight, inclusion of an ESG component in the identification of the appropriate bucket, a new risk factor, and usage of the RRAO framework?
Given the even shorter horizon of the trading book provision, incorporating potential climate disasters stemming from finance and investments into the model would not make sense.Rather, the exposures in the trading book must be added to the relevant large exposures to harmful assets under the LEX regime.
Q24: For the Internal Model Approach, do you think that environmental risks could be better captured outside of the model or within it? What would be the challenges of modelling environmental risks directly in the model as compared to modelling it outside of the internal model? Please describe modelling techniques that you think could be used to model ESG risk either within or outside of the model.
Given the even shorter horizon of the trading book provision, incorporating potential climate disasters stemming from finance and investments into the model would not make sense.Rather, the exposures in the trading book must be added to the relevant large exposures to harmful assets under the LEX regime.
Q25: Do you have any other proposals on integrating environmental risks within the market risk framework?
In general, the Pillar 2 framework is equipped to capitalise risks inadequately captured in the Pillar 1 market risk framework, such as environmental risk. Banks should quantify internally the capital charges related to environmental risks that are not properly capitalised under the Pillar 1 market risk framework. In addition, internal stress tests are better equipped to capture the longer-term characteristics of environmental risks.Q26: What additional information would need to be collected in order to understand how environmental risks impact banks’ operational risk? What are the practical challenges to identifying environmental risk losses on top of the existing loss event type classification?
We welcome the EBA’s approach by which climate-related risks are not a new category of risk but drivers of existing risks. Therefore, we consider the existing operational event types to be sufficient, as they cover types of events that may be caused by climate/environmental risks.Practical challenges relate to:
1. Identification taking into account certain info that is not routinely captured in the event logs, only in case the most relevant ones.
2. Lack of automatization when using data.
3. The use of operational risk taxonomies different from the regulatory existing ones may create overlaps or confusion, including the development of banks’ internal systems
4. Quantification, as access to climate data and forecast possibilities are limited
5. The identification of the right kind of information that helps to capture the operational risk losses due to environmental factors (including the development of potential proxies, considering that there is not yet established historical information)
6. Collecting information at subsidiary level to capture operational risk losses that can be used for meaningful comparisons, because the work being performed on sustainability is not always comparable across countries or developed at the same pace, and this could hamper the comparability of the information collected.
Q28: Do you agree that the impact of environmental risk factors on strategic and reputational risk should remain under the scope of the Pillar 2 framework?
Yes, we agree that the impact of environmental risk factors on strategic and reputational risk should remain under the scope of the Pillar 2 framework. This also applies to litigations received due to strategic decisions on the business model that may result in institutions failure to address negative impacts on the environment.Nevertheless, guidance is expected to prevent the development of an unlevel playing field. It is important when developing these guidelines, the EBA should take into account that given that supervisory exercises are already ongoing, the flexibility regulators and supervisors are providing in terms of methodologies needs to be maintained over time given the large-scale investments that banks are undertaking to develop methodologies and internal systems.
Q30: What, in your view, are the best ways to address concentration risks stemming from environmental risk drivers?
In our view, the best way to address concentration risks stemming from environmental risk drivers would be to highlight the main exposures to sectors, geographies, markets, counterparties or economic groups that are exposed to a material environmental risk and which must be phased out in order to prevent climate disasters from materializing.Moreover, from the relevant section of the discussion paper we understand that the potential thrust of such concentration risks is not limited to a high risk of natural catastrophes like flooding, earthquakes or wildfire, but could also potentially include steering of exposure concentrations to environmentally harmful sectors, like the mentioned carbon-intensive industries. This is why integrating climate risk exposures in the LEX regime is justified. Regulation should shield banks from getting involved in new potential stranded assets, and it should steer their efforts to guide clients into the transition, and as such prevent materializing financial risk on a >10 year horizon.
Q31: What is your view on the potential new concentration limit? Do you identify other considerations related to such a limit? How should such a limit be designed to avoid the risk of disincentivising the transition?
In the first place, calling climate risk a “risk” in the context of finance is a fundamental mistake. Risk calculations are based on historical data. But we cannot predict potential outcomes of climate disaster, nor will we ever have data to estimate this risk. Instead, banks would be wise to focus on managing “uncertainty”, as meant by Knight (1921), and apply the Large Exposures (LEX) regime to mitigate the effects of potentially compounding risks.The LEX regime of the Basel framework already provides banks with ample opportunity to limit disproportionately large losses that could arise in the event of counterparty failure due the occurrence of unforeseen events.
Second, climate “risk” is a compounding risk, aggravating potential losses when more exposures are added, as opposed to the traditional credit, liquidity and market risks that banks can diversify. It is very difficult to follow movements of climate risk and find a pattern that may make outcomes predictable with assigned probabilities. Rather, compounding risks are identified when stress testing a normal situation against extreme situations. Or worse, group risks materialize in a crisis, when the group is hit by a shock and vulnerabilities across the group are revealed.
The proper way to deal with uncertainties in banking is to impose limits, ring fence vulnerable portfolios, and introduce behavioral interventions (you can do this, but you cannot do that). Simply put, reduce vulnerability exposures. The LEX regime imposes additional buffers in case a bank exposes itself to too much of something that seems good (e.g., sectors, business families, or regions), thereby increasing the risk of incurring large losses due to contagion.
There is no capital requirement for addressing climate risk other than full deduction, which may not even be enough. It is therefore pointless to try to find data for estimating climate-related risks. The only way that banks’ exposure to climate risk can be decreased is through setting large exposure limits, based on financed emissions paths that reflect the IPCC scenarios as well as on existing legislation that announces which assets (like cars, or deforestation) are phasing out.