European Regulator to Revise Pillar 1 to Include ESG Risk

European investment firms and banks will soon be required to adjust their risk assessments to factor in environmental and social risks, which Europe’s banking regulator says could threaten the stability of the entire financial system.

The European Banking Authority is calling for financial firms to accelerate the integration of environmental and social risks within capital requirements known as Pillar 1, which requires firms to calculate minimum regulatory capital for credit, market and operational risk.

A recent report from the regular stated that environmental and social risks are changing the banking sector’s risk profile and are expected to become more prominent. It suggested revisions of the Pillar 1 framework to reflect the growing importance of environmental and social risks. According to the EBA, the proposed changes are intended to support the transition to a more sustainable economy while also ensuring that the banking sector remains resilient.

“Economies and societies are increasingly facing the complex and severe consequences of

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climate change, biodiversity loss, resource depletion, inequality, migration and other

environmental and social concerns,” the report stated. “Through their effect on traditional categories of financial risks, such as credit, market and operational risks, environmental and social factors are expected to more significantly contribute to risks to both individual institutions and financial stability as a whole.”

The EBA is proposing five short-term actions for firms to take over the next three years:

Include environmental risks as part of stress testing programs;
Include environmental and social factors as part of external credit assessments by rating agencies;
Include environmental and social factors as part of due diligence requirements and valuation of immovable property collateral;
Identify whether environmental and social factors constitute triggers of operational risk losses; and
Develop environment-related concentration risk metrics as part of supervisory reporting.

The EBA’s report also noted that it has considered introducing risk-weighted adjustment factors known as green supporting factors and brown penalizing factors. GSFs are intended to reward so-called “green” investments by reducing capital requirements for environmentally sustainable exposures, while a BPF aims to punish investors by increasing capital requirements for environmentally harmful assets. However, the EBA does not believe they should be introduced “at this stage,” noting that the use of the adjustment factors presents challenges in terms of design, calibration and complex interaction with the existing Pillar 1 framework.

“The EBA will, pending progress to overcome the challenges associated with such adjustments, reassess if and how environment-related adjustment factors could be designed as part of a prudentially sound and risk-based prudential treatment of individual exposures,” the report stated.