EBA Recommends Enhancements to Pillar 1 Framework for Environmental and Social Risk Management

The key recommendations include:

• integrating environmental risks into stress testing programs,
• encouraging consideration of environmental and social factors in credit assessments,
• incorporating environmental and social factors in property collateral valuation,
• identifying environmental and social factors as operational risk triggers, and
• developing environment-related concentration risk metrics progressively as part of supervisory reporting.

In the medium-to-long term, the EBA suggests enhancing forward-looking elements with scenario analysis, underscoring the role of transition plans in future risk-based enhancements to the Pillar 1 framework, reassessing the IRB supervisory formula and the corresponding standardized approach for credit risk to better reflect environmental risk elements, and introducing environment-related concentration risk metrics under the Pillar 1 framework.

The EBA’s recommendations underscore the rising significance of environmental and social risks in the banking sector. By integrating these risks into risk management practices, banks can proactively tackle sustainability challenges, bolster resilience, and contribute to a more sustainable and responsible financial system. Effective implementation of the proposed revisions and additions will necessitate collaboration among regulators, banks, and stakeholders to align with evolving environmental and social considerations.

Moving forward, on January 18, 2024, the EBA initiated a public consultation on draft Guidelines for the management of Environmental, Social, and Governance (ESG) risks. These guidelines aim to assist financial institutions in integrating ESG risks into their conventional risk management frameworks. The consultation period, comprising 26 questions, will run until April 18, 2024, with the final guidelines expected by year-end.

Key points from the draft guidelines include robust governance arrangements, distinction for small and non-complex institutions (SNCIs), risk identification and measurement, counterparty risk assessment, managing and mitigating ESG risks, integration into business and risk strategy, and monitoring and reporting.

The draft guidelines aim to harmonize practices and provide guidance to financial institutions. By integrating ESG risks into their risk management frameworks, institutions can enhance their ability to address sustainability challenges and contribute to a more sustainable financial system. The guidelines address various aspects, including risk identification, measurement, management, and monitoring, while considering the distinctive nature and forward-looking aspects of ESG risks. The consultation process allows stakeholders to provide feedback and contribute to the development of a comprehensive framework for managing ESG risks in the banking sector.