Financial supervisors have turned their attention to environmental, social and governance (ESG) risks. The European Banking Authority (EBA) has joined the effort by publishing technical standards on Pillar 3 disclosures for institutions in the European Union. With submission of the first full report scheduled for March of 2023, based on data that they are already supposed to be gathering, firms have little time to spare to prepare their people and processes for the new requirements.
Here is a five-step approach to steer them in the right direction. That is the intention, anyway, but because so much of the EBA’s framework remains up in the air – final rules and procedures still have not been established, and significant changes remain possible – any guidance must be broad and subject to change. The EBA understands the difficulties that this will impose on banks, though, and it is offering considerable leeway.
As the authority solidifies the procedures it expects banks to follow, it is important to keep things, well, fluid. A useful approach is to be faithful to the spirit of the framework more than the letter. There may be little choice, as the letter is likely to keep changing, but doing this will permit you to keep your thinking as open as possible, a handy way to tackle this comparatively novel subject. That should keep you compliant and ensure that your lending and other activities align with your financial and ethical objectives related to ESG criteria, too. Following these steps, therefore, should help you to gear up not just for the introduction of ESG risk disclosures, but for the inclusion of ESG-related factors into the way you think about your procedures and portfolios generally.
Step 1: Set an ESG strategy and risk appetite.
A bank will have to determine just how green it intends to be with respect to its lending and investment practices, and its reputation. Will it be carbon intensive, carbon neutral or somewhere in between? Whatever it decides, it probably will have to take actions to bring its policies, practices and portfolios into line with its philosophy. That means reducing investment in some sectors and increasing it in others. This is likely to alter the bank’s risk profile. Greater exposure to fossil fuel and other less environmentally friendly businesses will be riskier propositions, but ones that could offer greater returns. Conversely, greener lending could mean less ESG risk and lower returns.
Be careful, though, for it is possible to err on the side of caution in an incautious way. If a bank loosens its lending standards to emphasize indisputably ESG-friendly borrowers, such as providers of renewable energy, its credit risk may rise, and its exposure to such a narrow niche may create concentration risk. That is especially true if many banks have the same idea. There is even a term for this: the green bubble effect. A world that runs on sunshine and a stiff breeze may seem ideal, but extending an inordinate amount of credit to try to bring it about may not be.
Once you have set your strategy, assessed your risk and defined your risk parameters, you need to put your strategy into motion. Establish a handful of key points of interest – ESG objectives to be acted upon at the operation and process level – and assess them using the Green Asset Ratio (GAR) and Banking Book Taxonomy Alignment Ratio (BTAR), which measure how well a bank’s activities conform to EU green standards and climate goals, respectively, as metrics for your portfolio.
Step 2. Focus on processes, not on the report.
Steer your processes and investments so they conform to your key points of interest. Keep track of your data over time on GAR/BTAR metrics to see how well you are progressing from your starting point to significant targets, such as the 50 percent reduction in carbon emissions by 2030 called for under the 2015 Paris Agreement. Continual assessment will tell you how much adjustment you still have to make to meet your carbon intensity, financed emissions and other objectives, and which levers to pull to make your targets and get back on track if you have strayed. You will need to translate your analysis into concrete actions, such as changes to your loan origination processes.
Step 3. Be ready for change.
About the only aspect of the disclosures rubric that you can expect to stay the same is the prospect that rules and procedures will change right up until the first submission is due, and probably beyond. The broad objectives of the framework may be adjusted. Even if they are not, regulators, their governmental overseers and other stakeholders may seek additional or different details from banks, forcing measurements and reporting to be fine-tuned. New scenarios will have to be considered, models will need updating. It could be five years before standards, regulations and methods converge and a consistent set of procedures is in place. Amid such lingering uncertainty, you should not devote too much time, capital or faith to a single vendor, method or technology solution. Make sure that any vendor or solution you do use has sufficient flexibility to adapt to regulatory changes, and to changes demanded by the evolution of your firm’s business.
Step 4. Check your expectations and roadmap.
While many specifics in the disclosures regimen remain to be settled, there are clear expectations covering data delivery and reports tied to the calendar. Through the end of 2023, banks will have to gather qualitative information and be able to quantify a variety of asset exposures:
- Taxonomy-eligible activities and non-eligible activities
- Central governments and central banks
- Undertakings not subject to the Non-Financial Reporting Directive (NFRD), an EU law that requires certain large companies to disclose ESG-related information
- Trading portfolio
- On-demand interbank
Your data and procedures will have to be refined and finalized over the succeeding two years. You will have to develop methods for gathering information on emissions, environmentally sustainable exposures, measures of physical risk and so forth to fill in the templates in the disclosure report, and you will need enough time to roll them out and test new processes. You can verify your approach with tier banks or vendors, or have a third party check your work. This time should be used to gather information, build your data collection capabilities and hone your allocation process.
Step 5. Build on what you have, consider big changes later.
Whatever path you set your institution on, do not blindly follow it without checking the map and a compass frequently along the way. Take the opportunity to learn and adjust your processes, not just into the first submission date but well past it, as changes in how you do things – and are asked to do them – arise. When it comes to risk models, particularly, it is probably better that you experiment with what you have available now; there is no need to reinvent the wheel when the terrain you are rolling on, and your destination, keeps changing. Wait until there is sufficient regulatory convergence so you can be more certain where you are and what you need to do next. Meanwhile, as you start back-office projects, always factor the new ESG reports into your processes. Continually review where you are and where you are headed, and consider whether practices for certain activities are sufficiently mature to be incorporated into your more strategic, long-term thinking.
Much that is new, but much that bankers are used to
Assessing and disclosing ESG risks is a novel undertaking for financial institutions, with the details still being hammered out. But there are elements of the procedure that will seem familiar. Some present challenges, for sure, but they can be turned into opportunities with an openminded, farsighted approach that makes the most of what is known today, while doing as well as possible to prepare for a tomorrow that may be even harder to predict than it was yesterday.
One challenge arising from the disclosures framework, and the developing ESG risk regimen generally, that banks are accustomed to is the need to assess and disclose a risk that is composed of various others – liquidity, credit, counterparty, concentration, perhaps more – that are all related to one another. The context is new – ESG and climate change – but the fundamental process is not.
What is also not new is the need to determine your potential exposure to this set of interconnected risks for purposes beyond compliance and reporting. Deciding whether to make a particular loan, and at what price, based on estimates of risk that may factor in circumstances that are difficult to quantify, is what banks do in the normal course of business. So is assembling these many individual decisions, plus other inputs and analyses, into strategic forecasts and plans that steer them into the future.
The solution that will help institutions come to grips with the complexities, uncertainties and continual change of ESG risk also will be familiar to bankers that have had to master thematically and analytically similar supervisory frameworks over the last decade: a fully integrated data management architecture encompassing all of an institution’s major functions. As you take the first step, or five, on the road to meeting the EBA’s new disclosure obligations, the flexibility, adaptability and comprehensiveness of such a solution will allow you to address them, and leverage the information for strategic commercial purposes, too, as long as you are open to new possibilities that the framework creates, not just new necessities.