The European Central Bank has published the results of its thematic review on climate-related and environmental risks, which includes the compliance deadlines for banks, together with a compendium of good practices that it observed in some banks during its review.
The thematic review, which was conducted in tandem with the first supervisory stress test on climate-related risks in July 2022, was intended to check whether banks adequately identify and manage climate-related risks as well as environmental risks such as biodiversity loss (“C&E risks”). It also considered banks’ risk strategies and their governance and risk management processes.
Fast approaching deadlines
The review which covered 186 banks, including “significant banks” under direct ECB supervision and “less significant banks” supervised by national authorities, shows that banks are still far from adequately managing climate-related and environmental risks. Consequently, all banks received comprehensive feedback letters following the review, identifying on average 25 shortcomings and setting out institution specific remediation timelines.
As a minimum, the ECB expects all institutions to meet the following milestones:
By March 2023
Banks are expected to adequately categorise C&E risks and conduct a full assessment of their impact on banks’ activities (for all business areas, in the short, medium and long term).
By end of 2023
Banks must manage C&E risks with an institution-wide approach covering business strategy, governance and risk appetite, as well as risk management, including credit, operational, market and liquidity risk management.
By end of 2024
Banks must be fully aligned with all supervisory expectations on C&E risks outlined in the ECB’s 2020 Guide on climate-related and environmental risks, including having in place a sound integration of C&E risks in their stress testing framework and Internal Capital Adequacy Assessment Process (ICAAP).
The ECB warns that these deadlines will be closely monitored and, if necessary, enforcement action will be taken.
The outcomes have also been incorporated into the 2022 Supervisory Review and Evaluation Process (SREP), with binding qualitative requirements being imposed on more than 30 significant institutions and a small number of banks seeing their SREP scores, and therefore their “pillar two” capital requirements, impacted..
Whilst most institutions have clearly built up their capabilities as compared to 2021, and over 85% of institutions now have in place at least basic practices for most areas of supervisory expectation, the approaches still lack methodological sophistication i.e. the use of granular information on C&E risk and/or active management of the portfolio and risk profile.
There is supervisory concern that banks continue to significantly underestimate the breadth and magnitude of risks. The ECB found “blind spots” at 96% of banks in the identification of C&E risks in key sectors, regions and risk drivers, of which 60% had “major gaps”. Where banks do assess the risks, they are not yet able to grasp the full magnitude as most do not actively collect granular counterparty, facility and asset-level data. Almost all boards are still unaware of how these risks will develop over time, what precise risk level the bank can accept and what action it will take to rein in excessive risk.
Banks have started to plan for the transition to a low-carbon economy and engaged with their clients on this transition. However, the ECB notes that a ‘wait-and-see’ approach still prevails. For example, banks do not set interim targets or limits to their risk-taking with a view to fulfilling their long-term strategic commitments, or set them so that they have a negligible immediate impact on the bank’s business.
About half of the banks reviewed were found to have failed to implement C&E practices effectively. Institutions were found to show a “strikingly low” appreciation of capacity and resource needs. And, even where concrete targets and limits were found to exist, the current ambition level was found to have no impact on the bank’s existing exposures, business model and risk profile.
Two thirds of banks were found to have started working on targeting broader environmental risks, including biodiversity loss, water stress and pollution. However, these remained in most cases limited to high level considerations of risk drivers in materiality assessment and/or to define basic exclusion criteria to avoid adverse environmental and reputational impacts.
On a positive note, good practices were observed in 25 out of 30 areas under investigation, including in traditionally more challenging ones, such as data governance, risk classification and pricing, demonstrating that swift progress is possible. The ECB has published a compendium of 26 good practices observed in some banks. Examples include:
Some banks are already using transition planning tools which involve using scientific pathways to assess the alignment of their portfolios with the Paris Agreement. The banks take actions when individual clients are not on track to meet the objectives set and address cases where engagement fails. Ultimately, such action can include abandoning client relationships.
Some banks have been observed mapping out data needs for their disclosures, risk management, business objectives and commitments. They collect data from a variety of internal and external sources. The banks tend to favour actual client data, which they collect from a broad customer base via questionnaires (and they are experimenting with ways of encouraging customers to fill in those questionnaires). When acquiring data from third-party providers, the banks assess the methodologies used and the quality of the data supplied. In taking this approach, banks ultimately aim to report granular risk indicators to their board, providing a forward-looking view on risk exposures.
When assessing capital needs, some banks take into account forward-looking climate and environmental factors over a longer time horizon. These assessments cover both physical and transition risks. Frontrunners have even put aside capital specifically to manage material climate-related risks based on the outcome of their capital adequacy assessments.
The ECB warns that “laggards need to catch up quickly” and banks must look further into the future and take the necessary action now to adjust before it is too late. It takes time to fundamentally adapt and design concrete pathways to maintain a resilient business model and with the first of the ECB minimum milestones approaching in Q1 2023, banks do not have long to take action.
The ECB press release is available here.
A blog post by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, is available here.