The EU’s prudential framework is based on the Basel framework. Its main purpose is ensuring the sound capitalization of institutions and fostering prudent risk management to mitigate any disruptions to the financial system. Although it includes mechanisms that allow the inclusion of new risk drivers, the forward-looking nature of environmental risks is not explicitly addressed under Pillar 1. However, it is important to recognise that the Pillar 1 own funds requirements do not have to cover all risks. Pillar 2 additional own funds requirements, based on institution-specific analysis performed by competent authorities, together with the Pillar 2 guidance allow appropriate consideration of different business models and specific risks, and can address the idiosyncratic aspects of environmental factors. Furthermore, any systemic aspects of such risks would need to be tackled by the macroprudential framework.
In May 2022 the European Banking Authority (EBA) published a discussion paper on the role of environmental risks in the prudential framework, enquiring whether targeted amendments are necessary and sufficient to effectively address them. The risk-based approach aims to ensure that the prudential requirements reflect the underlying risks and support institutions’ resilience, therefore the EBA’s focus was on exploring whether there are risk differentials of for instance assets associated with green or environmentally2 harmful activities. In parallel, at the international level the Basel Committee on Banking Supervision (BCBS) is also investigating the extent to which climate-related financial risks should be explicitly incorporated in the existing Basel framework, and its findings or policy recommendations will be also considered in the EBA’s final report, together with the conclusions of the European Commission High-Level Expert Group on Sustainable Finance, among others.
Beyond these work tracks, there is a consensus that certain risks, such as risks which are not fully captured by Pillar 1 and risk factors which are external to the institutions, should be treated under Pillar 2 instead. The potential amplifying affects of interactions and interdependencies among environmental risk drivers, their forward-looking nature, the risk concentration at regional and/or sectoral level, among others, certainly call for additional steps outside of Pillar 1 as well. To facilitate their due consideration and integration, both regulators and financial institutions are for instance working on incorporating climate risks into stress testing. For insights into the European Central Bank’s (ECB) recent climate stress test exercise, we refer to the previously published article: ‘The 2022 ECB climate stress test results – a roadmap towards future best practices’.
The ECB’s good practices guidance on developing sound climate risk data infrastructure and stress testing frameworks is expected to be disseminated in December 2022. In parallel with the stress test, in the first half of 2022 the ECB conducted an extensive supervisory assessment of institutions’ practices related to strategy, governance and risk management in the environmental risks’ domain, the preliminary conclusions of which can be consulted in our recent article: ‘2022 ECB Climate and Environmental risks agenda: preliminary indications’.
Additional efforts are being made for integrating environmental aspects into Pillar 3 too. For instance the EBA as part of its 2022 Annual Work Program monitors the implementation of the ESG disclosure standards. The corresponding Pillar 3 reporting requirements are already applicable with first snapshot date of end-2022, requesting institutions to publicly disclose granular environmental information.