EU banking regulator pulls plug on ‘green supporting factor’  

Attention will turn to banks, credit ratings agencies and regulators to ensure climate risks are accounted for.

Illustrations of US dollars

The European Banking Authority (EBA) has decided not to recommend the use of measures which could make financing green activities more attractive for banks, and financing environmentally harmful activities less so.

It has instead proposed a menu of options “and targeted amendments to the existing prudential regime” to address environmental risks among regulated institutions, while maintaining a risk-centred approach.

The move brings an end to a multi-year investigation by the EBA on whether there is evidence to support the implementation of dedicated prudential treatments for assets based on their climate exposure.

This would allow banks to reduce the amount of capital they are required to set aside for green assets or conversely increase the requirements for polluting assets – known as a “green supporting factor” or “brown penalising factor” respectively. The same approach could apply to other dimensions of environmental, and social, factors.

While the measures have not been introduced in any jurisdictions, there has been broad interest in their potential to boost green financing in Europe following the high-profile backing of former European Commission vice-president Valdis Dombrovskis, the European Parliament and the EU’s sustainable finance advisers, among others.

Detractors of the policy, which include London’s Grantham Institute, have said that it would make banks more vulnerable to default while doing little for the environment. A separate note by BNP Paribas slammed the prospective move as “pure political measure” in 2022, arguing that banks “should not be the primary enforcers of the EU climate policy”.

In its final report, published yesterday, the EBA indicated that it was unable to establish a clear link between E&S factors and “traditional categories of financial risk”, which would be required if it were to back such a measure.

In practice, supporting and penalising factors would be applied to Pillar 1 capital requirements, which are calculated internally by banks based on a predetermined formula, and set aside as a buffer against unexpected losses over the course of one year. It is separate to Pillar 2 capital setting, which is derived on a case-by-case basis via supervisory reviews.

The EBA said that adjustments based on E&S factors would be “crude”, and “cannot be fully determined in advance” for the longer time horizons over which these factors become material. In addition, it said that the policy could lead to double-counting as banks are already starting to integrate E&S factors into their broader prudential calculations.

The supervisor also expressed concerns that the policy could lead to “disproportionate risk taking”, while at the same time compromising the “reliability of capital requirements as indicators of risk… potentially undermining prudential objectives”.

Enhancements to Pillar 1

In view of the challenges of adapting the factor adjustments, the EBA has proposed “risk-based enhancements” to the Pillar 1 framework which would see more demands being made of banks, credit ratings agencies (CRAs) and regulators to ensure climate risks are accounted for.

Regulated institutions will be expected to identify whether losses incurred are linked to environmental factors, as well as to incorporate environmental factors into their own assessments of credit risks.

At the same time, CRAs “should be encouraged to progressively” integrate E&S factors into their assessments whenever relevant, said the EBA, although it noted “a high level of divergence” on the topic across different agencies at present.

“Going forward, disclosures should be enhanced to further facilitate the understanding of users of ratings on where E&S factors are affecting credit rating actions,” it said.

Credit ratings are vital inputs when making Pillar 1 calculations for around 54 percent of EU banks, while larger institutions with more complex operations tend to prefer the use of in-house risk management systems to derive their own credit assessments.

Finally, national supervisors will be expected to start collecting data on the impact of E&S factors on regulated institutions – in addition to environment-related risk metrics which are to be developed by the EBA. They will also be asked to verify that banks “explicitly integrate” E&S factors when carrying out due diligence on their clients.

The European Central Bank (ECB) – which acts to enforce the rules laid down by the EBA – has repeatedly stressed that sustainability factors are already captured by the EU’s existing prudential framework. It has already raised the capital requirements of a “small number” EU banks due to weaknesses in their climate risk management found in its annual supervisory review last year.

EU banks have until next year to meet the ECB’s 2020 supervisory expectations on the topic, which includes requirements for banks to assess the impacts of climate risks on their operations, establish a risk management framework in accordance with those risks and disclose meaningful information.

It is also expected that EU banking supervisors will be given new powers to assess bank climate transition plans as part of their Pillar 2 reviews, as reported by Responsible Investor last month.