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Highlights
- According to European Banking Authority (EBA) regulations, banks must quantify environmental, social, and governance (ESG) risks and provide a window into their business strategy, governance, and risk management.
- They must overcome data hurdles to build data systems, frameworks, and processes to collect, verify, and assure data.
- Cognitive technologies will help banks address data roadblocks and meet regulatory requirements in a cost-effective manner.
In this article
EBA regulations
In April 2022, the European Banking Authority (EBA) published its final draft of Implementing Technical Standards (ITS).
Since then, over 250 regulated banks in the European Union have been mulling over frameworks, systems, and processes to comply with the new regulations. They are expected to become compliant by June 2024, albeit in a phased manner. Banks are focusing on article 449a of the Capital Requirements Regulation (CRR), which mandates disclosure on environmental, social and governance (ESG) risks. It is expected to help capital markets reduce information asymmetry, mitigate environmental risks, and leverage new business opportunities while adapting to climate change.
Banks must quantify transitional and physical risks and provide a window into their business, strategy, governance, and overall risk management. This regulatory approach will foster transparency and accountability in the EU and global sustainable capital markets. It will also inspire independent banking authorities in other jurisdictions to adopt similar measures, which will help markets transition to a low-carbon economy.
Transitional risks
Banks are now required to report on the energy efficiency of their real estate assets covered by loans.
Additionally, they are expected to disclose their aggregate exposure to the top 20 most carbon-intensive firms in the world. Next, they will need to report the credit quality of exposures to Nomenclature of Economic Activities (NACE) sectors, emissions, and residual maturity. This will require institutions to establish frameworks, systems, and process to identify and report on Scope 1, 2, and 3 greenhouse gas (GHG) emissions of clients and their counterparties.
Finally, banks will need to disclose their banking books’ Scope 3 emissions with regard to alignment metrics defined by the International Energy Agency (IEA) for the ‘net zero by 2050’ scenario. Recognizing challenges around Scope 3 emissions reporting, the EBA has put in place transitional measures for institutions to begin reporting by June 2024.
Physical risks
Disclosures on physical risks will require banks to identify exposures by NACE sector and geography.
This will include exposure to chronic and acute climate hazards such as heat waves, droughts, floods, hurricanes, and wildfires. These narratives can be supported by incorporating climate data from public databases such as National Oceanic and Atmospheric Administration, PCA Global Drought Risk Platform, and the World Bank’s climate change knowledge portal.
Mitigating actions
The regulations have introduced two complementary key performance indicators.
These are the Green Asset Ratio (GAR) and Banking Book Taxonomy Aligned Ratio (BTAR). These KPIs will enable market participants to understand taxonomy-aligned financing activities to mitigate climate risks. They will also shed light on how banks are helping clients and counterparties transition and mitigate their own ESG risks. While the GAR is focused on large corporates and retail exposures, the BTAR focuses on smaller corporates. These activities are grouped by financial and non-financial corporations, households, and local governments.
Figure 1 illustrates the ECB risk disclosure timeline for EU banks.
The figure illustrates the European Central Bank’s ESG risk disclosure timeline for EU banks.
An infographic depicting the timeline for EU banks to quantify transitional and physical climate risks and take mitigating actions. Between 2022 and 2024, banks must disclose risks such as exposure to carbon-intensive firms and scope 3 emissions by sector relative to the International Energy Agency's alignment metrics. They must also make green asset ratio disclosures with respect to climate mitigation and adaptation.
Overcoming data hurdles
The EBA has recognized institutions’ challenges around ESG data management, specifically from their counterparties.
The disclosure of ESG risks presents two opportunities for banks. First, they can evaluate their own business models, lending activities, and risks. Second, it is an opportunity for due diligence and responsible engagement to help counterparties transition and mitigate climate risks.
To comply with this regulation, institutions’ board of directors must prioritize and incentivize identification and coordination among cross-functional teams to build data systems, frameworks, and processes to collect, verify, and assure data. Banks must prioritize embedding capacity-building measures to address ESG data challenges among smaller corporates, SMEs, and retail clients due to institutional capacity and know-how.
To that end, banks must leverage AI-backed ESG solutions and advisory services to align their portfolio with EU taxonomy, generate investment insights, and calculate the carbon footprint for SMEs. They must digitalize the energy-efficient mortgage process by leveraging cognitive technology and assess financial losses from climate change to assets and investments. This will enable the European banking sector to address roadblocks and meet regulatory requirements in a cost-effective and quality-assured manner. It will help clients demonstrate internal accountability, foster transparency, and restore trust among sustainable market participants while banking on new business opportunities to transition to a circular economy.
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