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It is clear that climate change and environmental degradation are already having a widespread impact on the real economy. They will also increasingly be reflected in banks’ balance sheets through both physical risks caused by weather events such as flooding, droughts and storms, and transition risks caused by the adjustment towards a less-polluting, more environmentally friendly economy. The impact of these risks is likely to be significant.
Early and decisive action by both banks and supervisors is critical to ensure that banks are resilient to these risks in the short and long term. Indeed, current prudential rules already require banks to identify, manage and disclose all material risks to which they are exposed. In view of this, the ECB published a guide on climate-related and environmental risks for consultation. The guide outlines how the ECB expects banks to consider these risks in their strategy, governance and risk management and how banks are expected to disclose them under the current prudential framework. “The window for a wait-and-see approach is swiftly closing, because the longer we wait the harder it will be to mitigate these risks,” said Patrick Amis, an ECB Director General, at an industry dialogue in June.
As part of the consultation, which closed on 25 September 2020, the ECB received around 800 comments from 50 respondents, ranging from banks and banking associations to research institutes and non-governmental organisations. Most respondents expressed broad support for the supervisory expectations. There were a number of common threads running through the comments received. For example, respondents asked what the ECB’s supervisory expectations are with regard to the impact that banks have on the environment; how supervisory expectations can be met in the short term given the challenges related to data and risk measurement methodologies; and where the ECB guide fits within the broader regulatory developments.
First, the ECB has adopted a risk-based supervisory approach to climate change and environmental degradation. ECB Banking Supervision considers its main contribution to the transition to lower carbon and more circular economies to be the preservation of the safety and soundness of banks under its supervision. After all, in Europe, setting a clear transition path for mitigating climate change and environmental degradation is first and foremost the task of democratically elected governments. Nonetheless, ensuring that banks’ balance sheets also reflect climate-related and environmental risks is a prerequisite not only for the resilience of the banking sector, but also for the accurate pricing of these risks. This, in turn, will contribute to an efficient and orderly transition to a low-carbon economy.
Second, the ECB is aware of the challenges that banks face in terms of data availability and the evolving nature of risk measurement methodologies, among other things. Nevertheless, timely and collective efforts are required across the spectrum. Banks are expected to assess whether their current practices are safe and prudent in the light of the ECB’s expectations and, if necessary, to start adapting them. ECB Banking Supervision will enter into a dialogue with banks in early 2021 to discuss whether their practices diverge from the supervisory expectations and to identify key areas for improvement. The ECB acknowledges that banks’ practices are expected to evolve over time, and does not foresee this to be reflected in across-the-board capital requirements. However, supervisory follow-up actions cannot be ruled out in certain individual cases. As of 2022, however, the ECB will start conducting in-depth supervisory assessments of banks’ practices. The ECB will inform banks under its direct supervision of the envisioned structure and content of the supervisory dialogue in due course.
Third, the ECB is closely liaising with the European Commission and the European Banking Authority (EBA) on this topic and will continue to develop its supervisory practices based on future regulatory developments. For example, the EBA is currently examining how environmental, social and governance risks can be considered in the prudential framework. The ECB will also continue to contribute to the work of the Network of Central Banks and Supervisors for Greening the Financial System and the Basel Committee on Banking Supervision in pursuit of global convergence of sound climate-related and environmental risk management and supervision in the financial sector.
Like the COVID-19 pandemic, climate change and environmental degradation are having, and will continue to have, an impact on the banking sector and society as a whole. Therefore, banks must act swiftly to ensure that they manage climate-related and environmental risks in a sound, effective and comprehensive way.