ESG Stress Testing Consultation Document
The European Banking Authority (EBA) releases an ESG stress testing consultation document aimed at guiding European financial regulators to incorporate ESG risks into stress testing activities.
The European Banking Authority believes that ESG risks have a significant impact on the stability of individual financial institutions and the overall financial system, and financial regulators should continue to include these risks in their regulatory review and evaluation.
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Introduction to ESG Stress Testing
The ESG stress testing consultation document will establish a common standard for EU ESG risk assessment methods and improve information transparency. Compared with traditional financial stress testing, ESG stress testing is a relatively emerging field, and due to the uncertainty of its data and models, financial regulatory agencies need to constantly adjust ESG stress testing methods. This consultation document can both incorporate ESG risks as part of the regulatory framework and serve as a reference standard for temporary assessments. Regulatory agencies should focus on the following two types of testing:
- Testing the capital and liquidity situation, as well as loss absorption capacity of financial institutions in the face of ESG risks in the short and medium term.
- Testing the adaptability of financial institutions to a range of ESG scenarios in the medium to long term.
The objects of ESG stress testing include:
- Investment portfolio: Divided by asset categories, such as corporate loans, mortgage loans, sovereign risk exposure, stock assets, and bond assets.
- Industry: Divided by industry, such as energy industry, real estate industry, and agriculture. For specific industries, they can be further divided, such as dividing the real estate industry into the commercial real estate industry and the residential real estate industry.
- Geography: Divided by region to assess ESG risk exposure in specific locations.
- Counterparty: Divided by individual debtor or group of debtors.
- Risk category: Divided by physical risk and transition risk.
The methods for ESG stress testing include:
- Top-down approach: Regulatory agencies conduct stress tests to ensure comparability of financial institutions and reduce industry burden.
- Bottom-up approach: Financial institutions calculate stress test scenarios themselves, improve more detailed analysis data, and summarize the results to regulatory agencies.
Regulatory agencies first conduct materiality assessments to determine which ESG risks have the most significant impact on financial institutions, considering their business models, investment portfolios, geographic locations, and industry activities. In the early stages of ESG stress testing, priority can be given to climate and environmental risks, and as stress testing methods improve, the scope of ESG risk assessment can be expanded. Regulatory agencies should also incorporate ESG factors into the overall stress testing framework and collaborate with different industries (banking, insurance, and securities) to simulate risk transmission channels and spillover effects between industries.
Reference:
Joint Guidelines Integrating ESG Supervisory Stress Test
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