Euro area banks’ risk management and disclosure practices in the area of climate-related and environmental (C/E) risks require significant enhancement according to the European Central Bank’s (ECB) recent stocktake on this issue.
The ECB specifically found that euro area banks’ C/E risk management and disclosure practices were ‘sparse and heterogeneous’ and that ‘most banks have yet to develop a comprehensive and forward-looking risk management approach’.
To this end, and in this context, the ECB has now issued its draft guide on climate-related and environmental risks for consultation. This is currently scheduled to apply to ‘significant institutions’ (SIs) - those banks directly supervised by the ECB, by Q4, 2020.
The ECB has also set out its intentions to finalise both a pilot climate risk stress test and continue preparatory work for its macroprudential stress test. Dates and details are yet to be confirmed.
Below we provide:
- an overview of the ECB’s recent stocktake on banks’ approaches to C/E risks;
- a summary of the ECB’s Guide; and
- information on the proposed stress tests.
We conclude that the proposed expectations will have far-reaching effects, in particular and most immediately for SIs, but also potentially for other banks in the Single Supervisory Mechanism (SSM).
Given the ECB’s above findings and the proposed and imminent application date, SIs need, in our view, to make prompt progress with implementing expectations contained within the Guide. We do not expect the ECB to make fundamental changes to its expectations following the consultation. It follows from this that, unless the ECB postpones the start date, SIs will have to be ready from end-2020 to begin explaining to the ECB how their current C/E risk management practices either match or diverge from its expectations.
The ECB assessed how euro area banks addressed C/E risks to inform its Guide. Whilst it found that the approach towards C/E risks varied according to the size, business model, complexity and geographic location of individual banks, there were common shortcomings across the population (accounting for ca 44% of total euro area banking assets). The key shortcomings are highlighted in the diagram below.
The ECB’s draft Guide sets out 13 supervisory expectations on how SIs should manage and disclose C/E risks. Whilst the emphasis is currently on climate risks, it is clear that the ECB’s expectations extend to environmental risks. Environmental risks include physical and transition risks flowing from e.g. biodiversity loss, water stress, pollution and resource scarcity. In our experience, banks have even more work to do in relation to environmental risks than on climate risks.
The Guide applies to SIs, though the ECB also recommends that National Competent Authorities also apply it when supervising other banks in the SSM.
Whilst the Guide is not formally binding, the ECB notes that it will serve as a basis for ‘supervisory dialogue’ with SIs and that they will be ‘expected to assess whether their current practices are safe and prudent in the light of [the Guide’s] expectations’ and ‘where needed’, to ‘promptly start adapting their practices’. The ECB currently envisages that, as part of the supervisory dialogue, from the end of 2020, SIs will be asked to inform the ECB of any divergences of their practices from those within the Guide. While the ECB acknowledges that SIs’ C/E risk management practices ‘are expected to mature over time’, on the current timetable SIs will need to be ready to set out, almost on a ‘comply or explain’ basis, how they stack up against the ECB’s expectations by the end of this year. Given how detailed the ECB’s framework is, this presents SIs with a heavy workload over the next seven months.
The FAQs accompanying the Guide also note that the ECB is currently working with the European Systemic Risk Board and EU central banks to finalise a pilot climate risk stress test. Preparatory work is also under way for an ECB macroprudential stress test which will draw on granular information and focus on 90 SIs across the euro area. No dates/further details for this have been provided at the stage.
A summary of the ECB’s expectations contained within the Guide is set out in the table below. It is worth noting that these expectations do not supersede existing regulations/ECB Guides (e.g, its Guide to the ICAAP) and are instead intended to be read alongside them.
For those firms adopting group policies in this area, it is also interesting to observe that the ECB’s expectations are quite similar to those contained in the UK Prudential Regulation Authority’s (PRA’s) 2019 Supervisory Statement, SS3/19, albeit that they are far more granular and detailed. The other key difference is that the PRA does not address environmental risks in its statement.
The ECB’s Guide and planned stress tests are intended to standardise practices across euro area banks with regards to climate and other environmental risks, and whilst the expectations within the Guide are not technically binding, it is clear that the ECB ‘expects’ SIs to act upon them - and to do so ‘promptly’.
Given the ECB’s findings about the current state of Eurozone banks’ preparedness for managing C/E risks, it seems clear that these expectations will have far-reaching effects - most immediately for SIs, but also potentially for other banks in the SSM in future, given the ECB’s recommendations for a wider application of the Guide. These expectations will ultimately require SIs to adopt a full end-to-end approach, with the knock-on effects felt across every aspect of their business.
Moreover, the intended application of the Guide by Q4 2020 means that SIs have only a small window in which to both conduct a gap analysis and start implementing the necessary changes.