ICAAP and ESG risks

A new Action Plan from the EBA and the ECB’s growing interest in ESG risks are tangible signs of an increasing supervisory focus on climate change and other ESG factors. Integrating ESG risks into ICAAPs will be challenging, so banks should begin tackling this now – if they are not doing so already.

The past two years have seen a step-change in the public debate over climate change and other environmental, social and governance (ESG) risks. Despite the problems posed by a lack of reliable, consistent data, many banks have begun the hard work of incorporating ESG factors into their risk processes and strategic planning.

As we enter 2020, it’s increasingly clear that European supervisors are also taking an active interest ESG risks. The ECB has yet to identify any supervisory expectations in this area, but dialogue with national authorities is ongoing and climate change was again identified as a long-term risk to banks in the Supervisory Priorities for 2020.

So how is the picture evolving?

Looking back, 2019 marked a step-change in supervisors’ focus on ESG. April saw the UK’s PRA publish its statement on managing climate change risks, and BaFin released its consultation paper on managing sustainability risks in September. The ECB’s announcement of its intention to integrate ESG risks into its 2022 Stress Test was also a wake-up call for many banks.

Momentum continued to build towards the end of the year. The most visible recent development was the EBA’s publication of a new Action Plan on Sustainable Finance in December 2019. This is the EBA’s response to its ESG risk mandate as set out in CCR2, CRD4 and the European Commission’s own initiative on sustainable finance.

The EBA’s Action Plan heralds a full programme of activity over several years, with key milestones likely to include discussion papers, reports and technical standards. It sets out a sequential approach covering strategy and risk management; key metrics and disclosure; stress testing and scenario analysis; and prudential treatment. Perhaps most significantly, the Plan specifically recommends that banks should start addressing ESG risks now, must avoid a ‘wait and see strategy’ and should put metrics, strategies and risk management arrangements in place as early as possible.

Less visible than the EBA’s Action Plan – but no less significant for banks - has been the ECB’s growing focus on the status of ESG risk management. Several major European banks have had in-depth discussions with their joint supervisory teams (JSTs) on integrating ESG risks into their ICAAP in recent weeks. The topics that JSTs are particularly interested in include:

• Senior Management’s views and action plans for ESG Risk;
• Level of integration of ESG Risks in the ICAAPs including in scenario analysis and stress testing;
• Availability of respective data for managing ESG risks; and
• Integration of ESG risk into front-to-end processes (e.g. Integrating ESG risks into credit underwriting processes).

Taken together, these initiatives are a clear sign that European supervisors no longer view ESG factors as reputational hazards, but as financial risks requiring proper identification, quantification, reporting, mitigation and management.

In short, ESG risks are no longer something that banks can ‘get around to’ once they have addressed other priorities such as 2020’s stress tests or the implementation of Basel IV. But this growing urgency poses some significant challenges. The definitions of most ESG risks are still evolving, and the field is characterised by patchy, uncertain and vague information. Managing these risks will require banks to make a bewildering number of qualitative judgements. When it comes to integrating ESG risks into their ICAAP, some of the greatest challenges for banks will be:

• Taxonomy, experience and data. Efforts to agree common definitions are underway, but for now banks will need to stay flexible in anticipation of future changes.
• Complexity. ESG risks interact with each other and with other risk types, requiring modifications throughout banks’ value chains and risk management frameworks.
• Political and social uncertainties. The scale of ESG risks are affected by the views and actions of governments, media and the public; again, flexibility will be vital to managing these changes.
• Quantification and additional capital requirements. It remains to be seen how, and when, binding regulations and capital requirements for ESG risks will be introduced.
• Sudden changes in market conditions. Changes to legal frameworks, customer preferences and investor sentiment can give rise to rapid and unpredictable ESG transition risks.

The need to integrate ESG risks into their ICAAPs may take some banks by surprise. But in fact, it is entirely consistent with the increasingly forward-looking approach of European supervision.

The priority for banks now must be to begin integrating ESG factors into their risk management frameworks, if they have not already done so. First steps could include holding structured discussions to understand current best practice and market thinking. This initial phase should help to identify strategies, road maps and high-level resource requirements. That in turn will help banks to develop target operating models and multi-year action plans. Managing ESG risks properly can also create major opportunities for banks, both on the product and on the funding side, helping to bring relief to the profitability situation of the banks.

Despite the undoubted challenges posed by ESG, this is no longer an issue that banks can avoid. Now is the time to act.