Financial services newsletter - Issue 2
Welcome to the second edition of our newsletter, where we cover some of the major developments across the financial services sector throughout the last quarter.
In recent months the European Banking Authority (EBA), the European Central Bank (ECB) and the Central Bank of Ireland (CBI) have demonstrated increased focus on Climate and Environmental (C&E) risks within the banking sector. This is evident from the release of key regulatory documents to increasingly regulate anticipated C&E risks. Below is a snapshot of some of those released:
It is essential for banks to act relatively quickly and demonstrate their commitment to tackling these risks. As noted above, this year, the ECB will conduct a thematic review and stress test of C&E risk, with the goal being to integrate these into the Supervisory Review and Evaluation Process (SREP) methodology. This will ultimately affect institutions Pillar 2 requirements. While the ECB acknowledges this is an area currently evolving, there is still a need for these expectations to be met.
Below, we discuss some important considerations from the above documents regarding risk management and C&E risks. Firstly, look at risk management frameworks overall, then turn our attention to individual risk areas such as credit, operational, liquidity and market based. From there, we will touch on stress testing and scenario analysis and finally discuss disclosures.
It will need to go beyond qualitative factors to gain meaningful insight as part of the materiality assessment process. Institutions should use available proxies and estimation techniques to quantify the materiality and impact on the business. This may enable a comprehensive framework from which to set a level of risk appetite and monitor the C&E risks evolution.
Quantitative Indicators can include but are not limited to:
Where risk drivers are difficult to quantify, an effort is needed to develop qualitative proxies outlined in the “ECB Guide to the internal capital adequacy assessment process (ICAAP)” from November 2018. Any proxies developed should be documented transparently that define the indicators and data used to develop these clearly. A reporting framework could consider a three-pronged approach, including data gap analysis, data collection and data management and reporting.
The CBI has made it clear that firms are expected to “understand the impact of climate change on the risk profile of the firm and to enhance their existing risk management frameworks to ensure climate risk identification, measurement, monitoring and mitigation”. This definitive statement indicates that CBI expects firms to integrate C&E risks throughout the risk management framework.
Credit risk has been identified as the area most exposed to C&E risk drivers by significant institutions. By introducing enhanced due diligence procedures and dedicated climate questionnaires, banks will obtain more climate-related data and, in turn, a clearer picture. Lending policies are also being adapted to include exclusions and phasing out processes of certain types of lending. Other factors to consider include:
It should be considered how C&E risks and future events could pose litigation, liability and reputational risks. There is an ever-increasing focus from stakeholders on emission reduction targets and financing extended to sectors with high rates of pollution. Continued levels of lending to these sectors have an inherent reputational risk but also could lead to a reduction of the client base. The compliance function should be utilised to assess pending regulations in this area to determine possible impacts. Consideration should be given to initiating a comprehensive review of processes to ensure the appropriate governance of transactions that could involve climate and environmental concerns.
Extreme C&E events pose a significant threat to liquidity and therefore natural disasters should be integrated into liquidity contingency plans. Greenwashing is another potential threat. C&E risks should at least be integrated with regular liquidity stress testing or the ILAAP exercise. The impact on the Liquidity Coverage Ratio (LCR) buffer from the threat of greenwashing can be measured by an effectively designed stress test scenario.
Market risk policies and processes should be updated to include C&E risks. These should also be incorporated into market risk measurement metrics and portfolio monitoring and analysis. Limiting market risk exposure to sectors deemed non-ESG compliant can be implemented in a phasing out approach, reducing exposure in a timely fashion. Implementing newly updated policies and processes with respect to market risk should not be limited to market risk arising from the trading book but should account for the banking book also. Effective phasing-out criteria and exclusion of certain business activities should be considered.
C&E risks should be integrated into regular stress testing frameworks. Physical risks such as floods or droughts are well defined; however, transition risk can be difficult to define. Transition risk scenarios could include the impact on the global economy of alignment with the Paris Agreement in either an orderly or disorderly fashion. These are more generally economy-wide scenarios as opposed to institution-specific.
For the Climate Stress Test that banks must submit from March of this year, the macro-financial scenarios are prepared to reflect possible future climate policies and assess both physical risk and a transition to a greener economy.
In January 2022, the EBA published the implementing technical standards (ITS) on Pillar 3 disclosures on ESG risks. The European Commission has adopted a proposal for a Corporate Sustainability Reporting Directive (CSRD). This Directive envisages the adoption of EU sustainability reporting standards. These are being developed by the European Financial Reporting Advisory Group (EFRAG)
A disclosure policy should describe definitions that support policy, including:
For each step, the policy should allocate the corresponding roles, responsibilities and tasks to the organisational units involved.
This article was first published in the Finance Dublin Yearbook 2022.
This website uses cookies.
Some of these cookies are necessary, while others help us analyse our traffic, serve advertising and deliver customised experiences for you.
For more information on the cookies we use, please refer to our Privacy Policy.
This website cannot function properly without these cookies.
Analytical cookies help us enhance our website by collecting information on its usage.
We use marketing cookies to increase the relevancy of our advertising campaigns.