What prudential tools are needed for more sustainable bank financing (Note)

Abstract:

• The current economic model relies heavily on fossil fuels and remains highly resource-intensive, calling into question its sustainability and living conditions on Earth.
• Banks continue to play an important role in financing the economy and can therefore have a significant impact on the transition to a more carbon-neutral and environmentally sustainable economy.
• Despite the development of regulations on ESG (environmental, social, and governance) risks in Europe, these remain incomplete to date, suffering in particular from a lack of clear requirements and coordination.
• No strong measures are currently being taken to compel banks to drastically reduce their exposure to activities with a significant environmental impact; the impact of ESG risk disclosures in Pillar 3 banking will depend primarily on investor sensitivity to these risks.
• We propose several complementary measures, ranging from the integration of environmental risk factors (physical and transition) into banks’ internal models/ratings and capital charge calculations to the imposition of limits on exposure to activities with a higher environmental impact. The choice of measure would depend on the characteristics of each institution (size, complexity, capacity to develop models, etc.).

Despite the commitments made by various governments and regulatory bodies to combat climate change, progress to date remains insufficient to significantly alter the trajectory of greenhouse gas emissions and move towards a more sober, resilient, and low-environmental-impact economy. Indeed, our economies continue to be heavy consumers of fossil fuels and other natural resources, jeopardizing their sustainability and that of entire ecosystems.

The latest IPCC report summary[1], published in March 2023, highlights that a drastic reduction in greenhouse gas emissions (by half by 2030) would be essential to keep global warming to 1.5°C compared to pre-industrial levels. This goal is particularly ambitious as it would require significant and profound changes in our economic activities.

Despite the strong growth of financial markets since the 1970s, banks still play a major role in financing the economy: according to the Bank of France, in 2019, bank financing accounted for 63% of non-financial corporations (NFCs) in France.

Banks can therefore play a crucial role in steering the economy towards more environmentally sustainable activities through their financing policies, provided, of course, that these policies are sufficiently active and do not « simply » follow the existing structure of economic activities. This means that through their lending and interest rate policies, banks can prioritize financing certain sectors and/or activities that can be considered sustainable within the meaning of the European Taxonomy on sustainable activities, over activities that are not[3]. This would require studying and reconsidering the trade-off between short- and medium-term profitability and the sustainability of banks’ business models. it is clear that without strong incentives from regulators, decision-makers in banks may well favor maximizing profitability over shorter time horizons (corresponding, for example, to the horizon of their mandate or their annual evaluations).

Despite significant developments in sustainability and ESG risk regulation in recent years, the regulatory framework is not yet sufficiently « determined » and binding in favor of sustainable finance. Furthermore, the articulation between the various existing regulatory texts sometimes reveals inconsistencies. The aim of this study is to analyze the various existing prudential tools promoting sustainable bank financing, assess their consistency, and propose some areas for improvement.

1. State of the art and analysis of the main existing prudential tools and how they interact

The guidelines on lending and monitoring issued by theEBA define a set of criteria to be taken into account in lending policy, including ESG factors, particularly environmental factors that constitute material physical and transition risks (geographical area at risk, current and projected greenhouse gas emissions, etc.). These guidelines can be effective in the granting phase (new loans) if a number of ESG criteria (particularly environmental criteria) are defined in a clear, precise manner (based on the delegated acts of the European Taxonomy, for example) and with sufficient rigor (use of data on emissions and energy consumption, waste produced, recycling, etc.), and are taken into account in calculating a counterparty’s « score » and credit quality.

Similarly, regular assessment of how these criteria are taken into account, with updates to credit risk metrics( probability of default PD and loss given default LGD), should be carried out to ensure consistency. According to the definitions of ESG risks given by the EBA in its report on ESG risk management and monitoring, these risks (particularly environmental risks) have a direct or indirect impact on the future financial health of banks’ counterparties and therefore on the level of credit risk they represent. Furthermore, in the same report, the EBA recommends that banks take ESG risks into account in their business strategy, internal governance, and risk management framework. However, there are currently no regulatory requirements for banks using internal models to take these risks into account in their credit risk assessment models. As a result, new or existing exposures to activities that are exposed to environmental factors, for example, do not see their credit quality deteriorate. The lack of regulatory requirements regarding the updating of banks’ internal/rating models is therefore inconsistent with the guidelines on ESG lending and monitoring, as well as with the recommendations set out in the report on ESG risk management and monitoring, which could be a first obstacle to the transition to more sustainable financing.

The Pillar 3 ESG Implementing Technical Standards (ITS)[8]introduce information on ESG risks (quantitative and qualitative for environmental risks, qualitative only for social and governance risks) into credit institutions’ Pillar III disclosures[9]. It provides investors and savers with insight into banks’ exposures to sectors that contribute significantly to climate change, as well as the measures taken by banks to mitigate these risks. Investors and customers of a bank would thus be able to know whether the bank finances activities that emit high levels of greenhouse gases and, if so, the share of financing for these activities in its portfolio, through two ratios: the ratio of « green » assets (i.e., aligned with the EU Taxonomy) (GAR) and the ratio of assets in the banking portfolio aligned with the EU Taxonomy (BTAR)[10].

This regulation can be effective insofar as it « puts at stake » the reputation of each bank with regard to the sustainability of its financing. Nevertheless, it indirectly assumes that investors and bank customers are sufficiently sensitive to environmental, social, and governance issues, which is not always the case. In addition, investors usually place greater importance on purely financial indicators (quarterly or annual). Furthermore, as the risk has not been materialized either by exposure thresholds not to be exceeded or by risk metrics that take environmental factors into account (the only metric taken into account is exposure), the risk criterion cannot sufficiently influence investors’ decision-making. The ITS P3 ESG regulation should therefore be supplemented by regulatory requirements, either in terms of alignment ratio thresholds for banks (GAR and BTAR), or exposure limits on sectors that are particularly high emitters of greenhouse gases and/or generate other types of pollution (water, soil, etc.), or by risk weighting that incorporates at least environmental criteria.

According to the latest version of the internal governance guidelines datedJuly 2021, institutions must take into account all the risks to which they are exposed, including ESG risks. An institution’s risks must therefore be in line with its strategy, objectives, risk appetite, culture, and values. These guidelines are supplemented by the guidelines on remuneration policy, whichemphasize the consistency of remuneration with the institution’s culture and values, its strategy and its long-term interests in terms of activity, risk appetite, and environmental, social, and governance criteria. Furthermore, according to these latest guidelines, the compensation policy must not encourage excessive risk-taking.

These two guidelines obviously constitute a promising foundation in terms of ESG strategy and risk mitigation. Nevertheless, as they stand, these guidelines seem to give institutions free rein to define their business strategy and risk appetite, without any strong requirements for internal policies with clear and well-defined long-term objectives. Such requirements could be a good lever for encouraging a reduction in exposure to unsustainable activities, thereby promoting long-term objectives and limiting short-term decisions that could compromise the sustainability of the institution’s business model. In addition, compensation policies should set clear long-term objectives (with intermediate stages of achievement) to encourage managers and employees to take greater account of sustainability aspects in their work.

Although the internal governance guidelines specify that institutions must consider all the risks to which they are exposed, including ESG risks, to the author’s knowledge, there are currently no regulatory requirements obliging them to integrate ESG factors (particularly environmental factors) into their risk models; this remains entirely voluntary on the part of institutions.

Finally, according to the latest version of the SREP guidelines datedMarch 2022, supervisors (i.e., the ECB and national authorities) must take into account ESG risks and their impact on the viability and sustainability of institutions’ business models and their long-term resilience as key vulnerabilities. However, following requests from banks that reported data and methodology gaps in the area of climate stress testing, the EBA has decided not to include climate risks in the Pillar 2 capital requirements and recommendations (P2R and P2G) for the time being[11]. Inclusion is planned for the next revision of these guidelines. Once again, the regulator does not require regulatory capital for ESG risks (particularly environmental risks) or their impact on existing risks, which does not provide sufficient incentive for banks to develop methodologies to understand and assess these risks, or to reduce their exposure to unsustainable activities as quickly as possible.

2. Prospects for the inclusion of ESG risks in the prudential framework

The CRR2 regulation mandated the EBA to express its opinion on whether and how ESG risks should be integrated into the prudential framework. The EBA will take a position this year (the date has been brought forward by two years following the CRR3 project).

In its 2021 report on ESG risk management and monitoring, the EBA had already recommended incorporating ESG risks into the supervisor’s prudential assessment process (SREP). This recommendation has been included in the European Commission’s proposed CRR3 text. However, for the time being, this does not give rise to regulatory capital requirements under Pillar 2. This will be the case when the SREP guidelines are next revised.

In any case, at this stage, the regulator seems to favor taking ESG risks into account in Pillar 2, in particular through the regular application of climate stress tests and a qualitative assessment of how ESG risks are taken into account in banks’ internal governance.

With regard to stress tests in general, the results of these tests give rise to capital recommendations (P2G), although this is not yet the case for climate stress tests. However, even if P2G includes climate/environmental risks, as these are by definition recommendations for additional capital and not binding requirements (unlike P2R), banks will not be obliged to build them up, although they are strongly recommended.

The qualitative assessment of internal governance may, on the other hand, give rise to capital requirements (P2R), although this is not yet the case. Nevertheless, this tool remains limited as it is based solely on a qualitative assessment of internal governance and does not quantify the ESG risks to which a bank is exposed, particularly environmental risks (physical and transition).

For the time being, there is therefore insufficient evidence to suggest that the regulator will consider taking ESG risks (particularly environmental risks) into account in the minimum capital requirements (Pillar 1), except through the possible introduction of a capital mitigation factor for exposures that have environmental objectives. However, although the introduction of such a coefficient could encourage more sustainable financing, this measure is not a sufficient deterrent to reduce financing for activities that are unsustainable but may offer sufficiently high short- and medium-term returns. No clear position has been taken by the regulator in favor of integrating environmental factors into banks’ internal models (let alone social and governance factors, for which the regulator’s current approach is purely qualitative), nor with regard to adding a category reflecting the sustainability of the financed activity to the risk weightings of the standard approach[13]. Finally, no limits have been imposed, either in terms of the ratio of green assets or exposures to unsustainable activities (i.e., defined as not aligned with the European Taxonomy). For these reasons, the effectiveness of the current regulatory framework can be considered fairly limited.

3. Some proposals to improve the current prudential framework in terms of sustainable finance

Below we list a few proposals that could strengthen the existing prudential framework on environmental risks and their consideration, while also analyzing the advantages and disadvantages of each.

The first proposal would be to include environmental risks (physical and transition) in banks’ internal probability of default (PD) and loss given default (LGD) models, which would have an impact on the calculation of minimum capital requirements (Pillar 1). This proposal would be consistent with the guidelines on lending and monitoring mentioned above, and would measure the impact of environmental risks on existing risk categories, particularly credit risk. This would lead to an increase in banks’ regulatory capital for activities considered unsustainable. On the other hand, the impact could be low or nil for activities that meet environmental criteria (low CO2 emissions, product longevity, use of short supply chains, low waste production, low environmental transformation/degradation, etc.). Nevertheless, banks need sufficient data and modeling expertise to implement this approach and build up additional regulatory capital, which presents a number of operational and financial challenges. For banks using the standard approach to risk weighting, a specific category could be created by the regulator by adding a condition on the level of environmental risk of a counterparty (based on alignment ratios with the Taxonomy, for example).

The second proposal would be to include environmental risks (physical and transition) in the calculation of economic capital[14] (Pillar 2). This could be done either by modeling credit risk parameters (PD and LGD) taking into account environmental factors solely for the calculation of economic capital, and/or via a multi-factor extension of the existing formula for calculating regulatory capital[15]. Taking these risks into account in economic capital allows the necessary precautions to be taken in terms of capital while leaving banks some flexibility in the calculation method. It also makes it possible to « pass » the supervisory review and evaluation process (SREP) and minimize any additional capital requirements or recommendations. As with the first proposal, banks must have sufficient data and modeling expertise to implement this approach. In addition, to develop a multifactorial capital calculation model, they must assess or simulate the exposures of their counterparties or portfolios to environmental risk factors, which could prove complex in the absence of sufficient historical data.

The third proposal would be to impose thresholds or limits, either in terms of green asset ratios (floor thresholds) or in terms of exposure[16] to activities considered unsustainable (limits/ceilings). This approach has the advantage of not creating an operational burden for institutions in terms of data collection and model development, while effectively contributing to a transition to a more sustainable business model. However, for this approach to be effective, it is necessary to reduce « generalist » financing that does not take into account the activity being financed, but only the financial status of the counterparty (which could be considered globally sound) and, where applicable, its alignment ratios with the Taxonomy at the consolidated level (if the counterparty is subject to this regulation or if it volunteers). Making financing more specific to activities would allow for more accurate consideration of their environmental risks. The disadvantage of this approach is that it depends on the quality of the counterparty’s disclosures, which banks would not always be able to verify unless they carried out a double assessment. In addition, counterparties with fewer than 500 employees (i.e., not covered by the Non-Financial Reporting Directive, NFRD, soon to be CSRD) are not required to comply with the European Taxonomy. Finally, in order to comply with the imposed limits, banks would have to (significantly) reduce or even stop financing certain activities or sectors if they are not aligned with the European Taxonomy, even going so far as to sell certain exposures as distressed assets (and therefore at a discount).

The overall objective being to significantly reduce exposure to unsustainable sectors or activities (which are not aligned with the European Taxonomy), each of these proposals could help achieve this objective. Depending on the size and complexity of each institution and whether or not it uses more or less complex internal models, the regulator could apply the most appropriate approach(es).

For small, non-complex institutions or those that do not have sufficient data or modeling expertise to implement models that integrate environmental risks, setting limits or thresholds in terms of exposure to unsustainable activities offers a comparative advantage. For institutions that are able to collect sufficient data and develop models, the regulator could require these risks to be integrated into existing financial risks (particularly credit risks) by calculating economic capital in the first instance.

Summary table

Conclusion

Several regulatory texts in recent years have been devoted to or refer to ESG risks and the sustainability of bank financing (Pillar 3 ESG implementing regulation, guidelines on loan origination and monitoring, SREP guidelines, internal governance guidelines, etc.). These texts mark an important turning point in prudential regulation, which previously only concerned purely financial risks. However, for the time being, there is still a lack of strong determination on the part of the regulator to consider ESG factors, particularly environmental factors, on the same footing as purely economic and financial risk factors.

As a result, ESG risks are not yet subject to capital requirements or other regulatory constraints, which seriously calls into question the effectiveness of the various regulations relating to these risks and sustainable finance. However, the impact of these risks can be significant, even harmful, for the entire economic and financial system. In addition, the relationship between the various regulatory texts currently presents a number of imperfections, even inconsistencies, in the overall regulatory framework dedicated to ESG risks.

In this note, we have proposed additional prudential tools that would strengthen the existing regulatory framework and that the regulator could apply according to the characteristics of each institution: ranging from simple exposure limits on non-sustainable activities as defined by the Taxonomy, to the evolution of internal models to integrate environmental factors, thereby giving rise to an additional capital charge (regulatory and/or economic). The choice of one solution or the other would depend on the complexity of each institution and its ability to collect and process the necessary data, as well as to develop models that integrate environmental factors.

References

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CSRD Directive (DIRECTIVE (EU) 2022/2464 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of December 14, 2022);

NFRD Directive (Directive 2014/95/EU of the European Parliament and of the Council of October 22, 2014);

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