On 12 October 2023, the European Banking Authority (EBA) published a report on the role of environmental and social risks in the prudential framework.

The report follows a discussion paper that the EBA published in May 2022 which initiated the discussion on the role of environmental and social risks in the prudential framework for credit institutions and investment firms.

The EBA is mandated under Article 501c of the Capital Requirements Regulation (CRR), and Article 34 the Investment Firms Regulation (IFR), to assess whether a dedicated prudential treatment of exposures related to assets, including securitisations, or activities (CRR), and of assets exposed to activities (IFR) associated substantially with environmental and/or social objectives would be justified.

The report recommends risk-based enhancements to the risk categories of the Pillar 1 framework. It also develops considerations on the potential use of macroprudential tools. The report explains why the EBA does not support the introduction of a green supporting factor or a brown penalising factor at this stage. The use of such adjustment factors presents challenges in terms of design, calibration, and complex interaction with the existing Pillar 1 framework.

In the report, the EBA sets out the following proposals:

  • Include environmental risks as part of stress testing programmes under both the internal ratings-based and the internal model approaches under the Fundamental Review of the Trading Book.
  • Encourage inclusion of environmental and social factors as part of external credit assessments by Credit Rating Agencies.
  • Encourage the inclusion of environmental and social factors as part of due diligence requirements and valuation of immovable property collateral.
  • Require institutions to identify whether environmental and social factors constitute triggers of operational risk losses.
  • Progressively develop environment-related concentration risk metrics as part of supervisory reporting.

In addition, the report also presents possible revisions to the Pillar 1 framework reflecting the growing importance of environmental and social risks, these include:

  • The possible use of scenario analysis to enhance the forward-looking elements of the prudential framework.
  • The role that transition-plans could play in the future as part of the development of further risk-based enhancements to the Pillar 1 framework.
  • Reassessing the appropriateness of revising the internal ratings based supervisory formula and the corresponding standardised approach for credit risk to better reflect environmental risk elements.
  • The introduction of environment-related concentration risk metrics under the Pillar 1 framework.

The EBA’s policy recommendations for investment firms include:

  • As a short-term action, the EBA recommends that the treatment of environmental and social risks for investment firms remain under the Pillar 2 framework for all K-factors including those related to risk to client (RtC). Accordingly, the EBA does not recommend changing, in the short term, the prudential framework for investment firms independently from the CRR.
  • As a medium- to long-term action, the EBA recommends extending the potential changes made to the CRR/Capital Requirements Directive IV framework to the investment firms’ prudential framework, where applicable. This would concern the parts of the investment firm framework that are directly or very closed related to the CRR. This includes the K-factors related to market risk, trading book concentration risk, credit valuation adjustment and counterparty credit risk. These should be replicated for investment firms, to ensure overall consistency while maintaining proportionality. Differences between the two frameworks, such as the use of the K-CMG, could be addressed previously recommended by the EBA.
  • The peculiarities of investment firms, including the overarching objective of having a simpler framework than credit institutions, should be preserved in the medium- to long term. This would apply, in particular, to the RtC key factors.
  • The EBA does not recommend introducing differentiating factors for commodity dealers in the scope of IFR/Investment Firms Directive as they currently apply the K-factors in line with the CRR and should apply the same requirements in case of any improvement in the CRR framework in the future for environmental and social risks. As a medium- to long-term action, the EBA will reassess, subject to further evidence and analysis, the appropriateness of introducing differentiating factors for commodity dealers to further reflect the concentration risk of those particular business models.

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