EU Bank Regulator Recommends Accelerating Integration of ESG Risks into Capital Requirement Framework

The European Banking Authority (EBA), a European Union banking supervisor, has unveiled a new report focusing on the integration of environmental and social risks within its prudential supervision framework for banks and investment firms. This initiative aims to accelerate the incorporation of these risks into the Pillar 1 framework, which outlines banks' minimum capital requirements.

Environmental and social risks are set to become increasingly significant, altering the risk landscape for the banking sector. These changes span various financial categories, including credit and market risk, as well as operational risks. They have the potential to impact individual institutions and the overall stability of the financial system.

The EBA's report provides a series of short-term recommendations to be implemented over the next three years. These include:

• Integrating environmental risks into stress testing programs.
• Promoting the inclusion of environmental and social factors in external credit assessments conducted by credit rating agencies.
• Incorporating these factors into due diligence requirements and the valuation of immovable property collateral.
• Requiring institutions to identify if environmental and social factors trigger operational risk losses.
• Developing environment-related concentration risk metrics as part of supervisory reporting.

In the long term, the report suggests potential revisions to the Pillar 1 framework to account for the growing importance of environmental and social risks. These revisions could encompass scenario analysis to enhance forward-looking elements, transition plans to further enhance the risk-based enhancements to the framework, and a reassessment of the internal ratings-based (IRB) supervisory formula and the standard approach for credit risk to better reflect environmental risk. Additionally, the report suggests introducing environment-related concentration risk metrics under the Pillar 1 framework.

Notably, the EBA report does not endorse the introduction of a "green supporting factor" to reduce prudential capital requirements for environmentally sustainable exposures or a "brown penalizing factor" to increase capital requirements for environmentally harmful assets.