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ESG: Embedding it into the banking prudential framework

Paul Young Paul Young

The European Commission recently published a study on the integration of ESG risks into the banking prudential framework. Paul Young looks at the headline findings and key considerations moving forward.

Taking stock of ESG implementation across the EU, the study assesses the consistency of supervisory expectations and the variation in banks’ approaches. This provides essential feedback for benchmarking and could indicate key areas of further regulation in the future. A responsive approach can help your firm stay ahead of the curve, meet customer expectations and keep on track with ESG risk management.

What is ESG?

The age-old problem is that banks, investors and supervisors do not have a consistent ESG definition. Many broadly view the term ESG as meaning climate risk and focus their efforts in that space, but the concept is considerably broader.

Part of the emphasis on climate risk, over other environmental, social or governance elements, is because it’s easier to immediately equate it with financial loss, which would impact prudential risk management. Banks typically link it to credit risk as the clearest transmission channel, but this can be a short-sighted view and reduce consideration of other traditional risk types such as market risk or operational risk. Similarly, banks tend think of social and governance factors in terms of reputational damage and strategic risk, and do not fully explore the financial impact.

Sustainability vs governance

As banks embed their ESG processes, a wedge is starting to emerge between environmental, social and governance topics. Typically, banks view environmental and social elements under the broad banner of sustainability. Meanwhile, governance is generally treated as a compliance topic rather than a risk factor in its own right. However, it’s important to consider how it could translate to other risks and the direct impact on financial stability. Good governance is also the backbone for effective risk management, so failings in this area could also compound any emerging social or environmental risks.

Supervisory consistency

When it comes to consistency, the problems don’t stop with the ESG definition or treatment of each individual risk factor. Regulatory supervisors in each country are also taking different approaches to ESG regulation and ESG reporting, and some have not prioritised it. Several supervisors are solely focused on ESG prudential risk management, as that falls naturally under their remit, while others are taking a more holistic view. There’s also a question over materiality vs double materiality, which looks at the material risks due to ESG factors, and material impacts on ESG due to the firm’s activities. They may require different degrees of regulation and could ultimately fall to different supervisory bodies to oversee.

Standardising these approaches will help supervisors create a consistent framework for risk management and reporting. Currently, SREP is the key tool to report on general ESG risks and the ICAAP is the main tool for reporting on the prudential impact of ESG. As best practice emerges, these tools could potentially be fine-tuned with greater mapping to the overall prudential framework. Some supervisors have already started mapping these risks and embedding them into pillar 2 processes. However, others are waiting for the changes to pillars 1 and 3 that are still pending from Basel, and are reticent to review ESG interactions with the prudential framework until they have been announced.

The ESG data isn’t there

In addition to issues around ESG meaning and consistency, ESG data is the next big problem - making it difficult to establish effective risk management approaches. Again, climate risk data is more readily available than broader ESG data, generally from both third-party sources and clients, but it’s often qualitative rather than quantitative in nature. Developing more quantitative ESG data will help firms manage their ESG risks internally, supporting reporting processes and enabling effective supervision by the regulators. It will also enable target setting and monitoring in the long term, helping to establish an appropriate risk management framework.

There’s also the question of whether to treat ESG as a cross-cutting or principal risk. While it doesn’t necessarily matter which method is followed, a standardised approach would make it easier for supervisors to compare the quality of implementation. Current ESG risk management approaches are patchy and often superficial in their application. Developing effective metrics and tools will help banks embed ESG into the risk management framework, including robust modelling and scenario analysis.

Business strategies and ESG investing

The lack of consistency is also overflowing into business strategy and ESG investing policies. While there are a range of ESG products available, they are relatively limited and often offered by a small number of banks. Additionally, monitoring and targeting practices may differ from bank to bank, potentially reducing their effectiveness and enabling greenwashing. From a lender’s perspective, the risk and return profile for these new products is still unknown, which could have a significant impact on product uptake over time.

The future of ESG regulation

Over time the ESG definition and associated practices will become more standardised, providing a stronger starting point for consistent ESG regulation and risk management. It will also help investors build confidence in the products and give greater assurance over greenwashing. But these changes will take time, and will largely depend on developing the right data to monitor and holistically target every element of ESG.

Contact Paul Young for further information.


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