As climate change and other ESG risks climb the global agenda, banks face a rapid increase in supervisory expectations. Growing scrutiny and the approach of 2022’s stress test make 2021 a crucial year. Banks must act now to integrate ESG factors into their risk management frameworks, while staying flexible and working to make their data, systems and processes to fit for the future.
Climate risk and other ESG risks have become an increasingly dominant theme of political, social and economic debate. Despite the difficulty of addressing these risks – most notably, the lack of reliable and consistent data – many banks have begun to incorporate ESG factors into their risk processes and strategic planning. Now, banks’ readiness to measure and manage climate and ESG risks is about to be tested.
Expectations are growing fast…
As we approach the mid-point of 2021, it’s clear that European supervisors are taking an increasingly active interest in ESG risks. As predicted in a previous publication, supervisory awareness and attention around ESG risks are evolving rapidly. Several publications point to a step-change in the ECB’s focus on ESG over the past six months:
- November 2020 saw the ECB publish its final guide to supervisory expectations for climate-related and environmental risks, covering 14 key areas including business strategy, risk appetite, organisational structure, reporting, scenario planning and disclosure.
- January 2021 saw the publication of the SSM supervisory priorities for 2021, stating that supervisors plan to focus on banks’ alignment with the ECB’s climate-related and environmental expectations.
- January 2021 also saw the ECB publish its assessment of the key risks and vulnerabilities facing banks in 2021. This identified climate change as one of the sector’s eight key risks alongside a prolonged downturn, a market correction, cybercrime and other risks.
Most banks across Europe have started change programmes to better include ESG aspects in their strategies, marketing efforts and risk management frameworks. At the same time, supervisory dialogue related to climate-related and environmental risks is ongoing, and significant institutions have been asked to conduct a self-assessment of their alignment with the ECB´s expectations by the end of February 2021, and to generate a roadmap for implementation by mid-May.
Banks were given a further wake-up call by the ECB’s plans to perform a dedicated climate-related risk stress test in 2022. Further details are due to be published later this year, but banks need to start preparing for what will undoubtedly be a challenging process – especially for institutions which have not yet begun to assess their exposure to the physical and transition risks of climate change.
Also the EBA’s intense multi-year work programme on ESG - covering areas such as strategy and risk management, key metrics and disclosures, stress testing and scenario analysis, and prudential treatment – is another sign of how quickly banks’ regulatory and supervisory environment is changing in the ESG space.
Finally, new requirements for ESG disclosures need to be implemented. The new requirements, introduced by the Sustainable Finance Disclosures Regulation (SFDR), the Non-Financial Reporting Directive (NFRD) review and also the new requirements being issued by the Corporate Sustainability Reporting Directive (CSRD) together with the new EU Taxonomy, require immediate actions by banks. Banks´ disclosures must take the EU taxonomy (goal 1 and 2) into account as of the financial year 2021. The new CSRD may become effective as from financial year 2023. This notably requires data collection and re-engineering of reporting processes and controls.
…Making 2021 a decisive year
In short, 2021 will clearly be a pivotal year for banks. At a minimum, institutions must address new supervisory expectations by adjusting policies, procedures, methodologies and infrastructures at the business unit, entity and group levels. However, banks should also seek to leverage the upsides of change wherever possible. Effective management of ESG-related risks will unlock major long-term opportunities in terms of product development and funding, helping to relieve profitability pressure.
We believe that addressing ESG related risks holistically across the organisation holds the key to success. That means that banks need to develop procedures and tools for identifying, assessing and following up on ESG-related risks arising from transactions and client interactions, before integrating those tools into standard risk and operational frameworks.
Institutions that are still beginning to address ESG should start with a gap analysis and a review of current best practices and market thinking. This will help to effectively identify the strategies, roadmaps and resources banks need to meet evolving requirements. That in turn will help banks to develop target operating models and multi-year action plans. Larger banks are generally more advanced in their ESG journey, also considering that the ECB addressed specific requests to them in order to assess their compliance with the supervisory expectations, but there still is a lot to be done. Overall, we would recommend that banks consider taking the following steps in the short term, if they have not already done so:
- Carry out a gap analysis, resulting in a clear action plan
- Specify clear bank-wide roles and responsibilities, with a reporting line to the CEO
- Enhance the management body’s involvement in climate-related risk assessments
- Conduct preliminary assessment of material risks, including initial analysis of climate-related and environmental risks
- Integrate ESG into business strategy, risk appetite statement, risk management framework and credit risk management
- Enhance data collection with regard to increasing disclosure requirements and expectations
- Develop/enhance climate-related scenarios, for use in stress testing and to enhance disclosures
While prioritising these immediate steps during the current year, banks should also keep an eye on the future. There are likely to be further supervisory enhancements over time, together with ongoing developments in regulation and taxonomies.
In the medium term, banks will therefore need to strengthen their KPIs and methodologies, enhance the availability of data, and more fully integrate ESG factors into risk management, business planning and strategy. Looking further ahead, banks will need to stabilise and continually improve their new ESG-related processes in the light of evolving stakeholder expectations if they’re to stay fit for the future.
Climate-related, environmental and other ESG risks are no longer issues that banks can afford to postpone. The time to act is now. Stay tuned for further insights soon, as we explore climate-related risks in a future publication in our “SSM beyond COVID-19” series.