Draft on ESG Risk Management
The European Banking Authority (EBA) releases a draft on ESG risk management to help the banking industry deal with social, environmental and governance risks arising from the EU’s climate transition.
EBA believes that the business model and risk profile of the banking industry are affected by ESG factors. The draft proposed this time will stipulate how banks identify, measure, manage and monitor these risks to ensure the sound operation of financial institutions. This draft allows a three-month consultation period, and stakeholders can provide feedback on the EBA website.
Related Post: EBA Releases Sustainable Finance Roadmap
Status of ESG Risk Management in Banking Industry
EBA believes climate change and environmental degradation are bringing huge challenges to the economy. These challenges have affected the transition between low-carbon economy and sustainable economy and have an impact on financial institutions. To deal with environmental, social and governance risks, the banking industry needs to systematically identify, measure, and manage ESG risks. However, due to the particularity of ESG risks and lack of historical experience, there are large differences in the practices of ESG risk management among different institutions.
In its observation of monitoring ESG risk management in the banking industry, the EBA found that most banks are still in the early stages of risk management, and these risks may still pose challenges to the banking industry’s business strategy and risk management. Therefore, incorporating short-term, medium-term, and long-term ESG risks into the banking industry’s internal governance and capital needs assessment is an important measure to manage ESG risks.
Identification and Measurement of ESG Risks
The first step in identifying and measuring ESG risks is a material assessment. EBA believes that banks should conduct a substantive assessment of ESG risks at least once a year, consider the impact of ESG risks on the market, liquidity, business model, operations, and reputation, and understand the financial materiality of these impacts. In terms of time horizon, the assessment should include short-term (less than 3 years), medium-term (3 to 5 years) and long-term (more than 5 years) and consider the use of both qualitative and quantitative data.
After substantive assessment, to complete ESG risk identification, banks should establish effective processes in data collection and processing, such as establishing a data governance framework, improving IT infrastructure, and regularly reviewing the reliability of counterparty disclosures based on existing data. Continuous information to obtain the required ESG data from multiple levels.
After obtaining ESG data, banks need to identify risk exposures to ESG factors to measure their financial risks. Banks can use exposure-based, portfolio-based, and scenario-based approaches to comprehensively assess ESG risks and calculate the bank’s sensitivity to different risks. For common environmental risks, banks need to quantify the probability and scale of these risks and establish Key Risks Indicators (KRIs) to measure the impact.
ESG Risk Management Measures in Banking Industry
The EBA has developed ESG risk management measures for the banking sector, including:
- Establish ESG risk management principles. Banks should regard ESG risks as traditional financial risks and incorporate them into regular risk management systems to ensure consistency with the overall risk strategy.
- Develop strategies and business models related to ESG risks. Banks need to understand the changes that ESG factors will bring to the economic and financial system in the short, medium, and long term, and how these changes will affect bank strategies and business models.
- Clarify ESG-related risk appetite. Banks need to understand the ESG risks they can take on in their businesses and investment portfolios and ensure that the KRI is consistent with the bank’s overall risk appetite.
- Cultivate ESG risk management talents. Banks need to provide training for managers and employees to understand ESG risks and provide three lines of ESG risk defense: business, risk management and internal audit.
- Implement ESG-based risk assessment. Banks can incorporate ESG factors into capital adequacy assessments and liquidity assessments and integrate them into credit risk assessments to accurately measure the impact of ESG risks.
- Set up an ESG risk monitoring process. The banking industry should regularly report ESG risks and develop a series of forward-looking ESG risk indicators to measure changes in ESG risks.
Reference:
The EBA Consults on Guidelines on the Management of ESG Risks
