EU banks get world’s first ESG rewrite of capital rules

The sun has set behind the buildings of the banking district and the European Central Bank in Frankfurt, Germany, Tuesday, Oct. 10, 2023. (AP Photo/Michael Probst)

Brussels: In a global first, Europe’s main bank regulator is revising the framework that sets capital requirements so that lenders reflect environmental and social risks in mandatory, industrywide buffers.

The European Banking Authority (EBA) has identified “some short-term fixes” to minimum requirements – known as Pillar 1 – “that can already be implemented,” chairman Jose Manuel Campa said in an interview. Others will be phased in over time, with some requiring new legislation, the EBA said.

The new requirements, outlined in a report published by the EBA last Thursday, mark the first in what’s set to be a continuous reworking of the capital framework within which European banks must operate. The goal is to reflect the increasing threat to financial stability that regulators now see from environmental, social and governance (ESG) factors such as climate change and inequality.

ESG is “changing the risk profile for the banking sector,” according to the EBA. The development is expected to become more pronounced over time and has implications for “traditional categories of financial risks, such as credit, market and operational risks,” it said.

Until now, regulatory focus has largely been on disclosure and individual bank risk (known as Pillar 2), due in large part to a lack of adequate data and methodologies for calculating sector-wide ESG risks.

The bank industry, meanwhile, has been emphatic in its opposition to such far-reaching capital requirements.

In response to an EBA consultation last year, the European Banking Federation said it’s against using Pillar 1 to address climate risks, arguing that capital assessments should allow for differences in bank balance sheets. Predicting losses also means relying on scenarios which are uncertain and shouldn’t be used to set capital levels, the industry group said.

The EU’s largest bank, BNP Paribas SA, warned separately that increasing capital requirements would hamper lenders’ ability to provide transition finance, without necessarily making the industry any more resilient.

Meanwhile, the EBA has rejected an industry call for lower capital requirements to encourage lending to companies that invest in technologies to address climate change, or penalties for exposure to heavy polluters.

Such a factor could mask risks, leaving banks without the necessary buffers and compromising “the reliability of capital requirements as indicators of risk,” the authority said.

Campa said the new ESG requirements are “very concrete.” But they won’t have the same impact on capital ratios as the so-called Basel III rules that followed the financial crisis of 2008, he said.

For now, the new ESG buffer rules aren’t “going to lead to a significant, discrete increase in the short term,” Campa said.

That’s in part because models for estimating the fallout of climate change, environmental degradation and inequality are in their infancy, compared with conventional risk management tools that have been built on historical data.

“There are a lot of areas that we need to understand better,” Campa said. “One thing that is interesting that we capture in this report – and it’s important for people to realise – is that as you think about regulation, we need to think differently about the methods that we have to assess this risk.”

The EBA report contains more than five pages of instructions to banks and national supervisors for short and longer-term changes. — Bloomberg

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European Banking Authority


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