ESRB advice on the prudential treatment of environmental and social risks

The European Systemic Risk Board (ESRB) has provided advice on the prudential treatment of environmental and social risks from a macroeconomic and systemic risk point of view to support the European Banking Authority (EBA) in its assessment of “whether a dedicated prudential treatment of exposures related to assets, including securitizations, or activities associated substantially with environmental and/or social objectives would be justified”. In this context, the ESRB acknowledges the current limitations in quantifying climate risks to derive prudential measures, but nethertheless highlights the importance of developing resilience in the financial system to support the economy during severe shocks, including those resulting from climate change.
Emphasis and flexibility in prudential policies:
The ESRB emphasizes that prudential policies should focus on ensuring the financial system’s resilience rather than driving the transition to a low-carbon economy. Considering the evolving nature of physical and transition risks linked to climate change, more efforts must be made and are currently underway to assess the prudential treatment of environmental and social risks. As more evidence becomes available, micro- and macroprudential authorities must be prepared to adjust their current prudential measures to address emerging risks.
The use of Systemic Risk Buffers (SyRBs) for prudential treatment of environmental risks:
The ESRB considers SyRBs as adequate tools to address systemic aspects of climate risks in the EU. SyRBs aim to deal with risks that might not be covered by existing regulations or requirements such as the Capital Requirements Regulation (CRR), the countercyclical capital buffer (CCyB) obligation, or buffer requirements for globally systemic important institutions (G-SIIs) and other systemically important institutions (O-SIIs). The ESRB believes that an SyRB, due to its flexibility in handling unexpected shocks, is well-suited to address severe external shocks related to climate change and enhance resilience.
The SyRB could be applied generally or on a sectoral basis, depending on the level of climate-related concentration risks of individual financial institutions. However, there is a need for a common methodology to calibrate these buffers and ensure a consistent approach across the EU. Furthermore, the sectoral SyRB should differentiate between borrowers with varying climate-related exposures and transition plans to avoid unintended consequences for climate financing.
The use of Borrower-Based Measures (BBMs) for prudential purposes:
BBMs, which aim to prevent excessive indebtedness of borrowers and mitigate risks related to real estate markets, can also play a role in addressing climate-related financial risks. While BBMs are not typically designed to consider climate risks, incorporating climate risk factors into their calibration can enhance overall risk assessment and management. The ESRB suggests reflecting climate-related financial risks in borrower solvency evaluations and collateral value assessments, allowing for adjustments in lending standards and conditions.
Many European countries are assessing the systemic relevance of climate risks and their impact on borrower solvency and collateral value. However, adjustments to BBM frameworks based on climate-related characteristics are limited. The ESRB recommends that BBMs be part of national macroprudential toolkits and of the toolkits of financial institutions designed to mitigate climate-related financial risks. As the application of BBMs requires the identification of how a particular institution or its customers are affected by climate risks and transition risks, more data needs to be gathered and further analytical tools be applied to derive an appropriate BBM measure.
The use of scenario analysis to assess climate change-related risks and derive prudential measures:
The ESRB acknowledges the importance of scenario analysis in refining the measurement of systemic climate risk exposures. While empirical evidence is valuable, the dynamic and unpredictable nature of climate change calls for a precautionary approach. The ESRB, along with other supervisory authorities, is working on developing plausible scenarios that combine climate change-related risks with other economic shocks. This exercise will enhance the understanding of rapidly emerging risks and contribute to the development of appropriate prudential measures.
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In conclusion, the ESRB notes that the immediate priority should be to utilize existing micro- and macroprudential tools consistently and transparently to address environmental and social risks. While major changes to the prudential framework may not be necessary, a forward-looking approach is crucial due to the evolving nature of climate change and related risks. Authorities need to strengthen their understanding of risks through scenario analysis and improve their capacity to model financial stability risks related to climate change and thus derive appropriate prudential measures for supervised institutions.