Jacob Gyntelberg's interview with FinansWatch: The European Banking Authority will reinforce the management of ESG risks

The European Banking Authority will reinforce the management of ESG risks

ESG risks can, among other things, affect a bank's credit risk, which can lead to increased capital requirements.

This is no longer seen as purely hypothetical risks by the European Banking Authority (EBA), but rather as real risks that can generate financial losses for banks. As with everything else that can generate financial losses, the new risks require banks to reserve capital to counter them.

The European Banking Authority (EBA) is currently in the process of updating its credit risk management guidelines, and in this context, the requirements for managing sustainability risks, or ESG risks, will be tightened. This is reported by Jacob Gyntelberg, Head of Economic and Risk Analysis at the EBA.

‘That particular work is underway, and we would like to have a draft of the guidelines by the end of the year or when CRR3 is published,’ he says, referring to the new capital requirements regulation, which was recently negotiated by the European Parliament and the Council.

At the same time, the EBA is attempting to develop new guidelines for national supervisory authorities (SREP), and the EBA is also mandated to develop an internal climate stress test for banks, where ESG risks are quantified.

The Danish supervisory authority may in principle choose to ignore the EBA, but, for the moment, the Financial Supervisory Authority implements all relevant guidelines from the European Banking Supervision, and the new guidelines, and the internal climate stress test, therefore impact all Danish financial institutions.

Integration of ESG into the overall risk picture

Most banks are already actively addressing ESG risks today. This is required by the Management Order. However, there are no guidelines on how to measure and manage these types of risks, and it is unclear what weight ESG risks should be given when banks reserve capital.

These are important questions for banks, as capital requirements are, among other things, a product of a bank's assets and the risk of those assets.

Jacob Gyntelberg reports that the new EBA guidelines will address how banks should integrate ESG risks into their strategy, governance and risk management, enabling banks to better identify ESG risks and their importance. It will not, however, be a separate risk category.

‘We look at them as drivers of credit risk, market risk and operational risk. These are not separate risks,’ he says.
The head of EBA emphasises that the new guidance, like the upcoming climate stress testing, will only address risk issues. The EBA will not interfere in whether the bank’s balance sheet is green, brown or black.

‘That is exactly what we want to avoid. So, if a bank is faced with a higher capital requirement, this is not due to it not being green. It will be, because it is not good at managing that part of the business in terms of understanding the risk profile and the importance of ESG as a driver of risk in its books,’ he says.

Therefore, a bank that only finances projects in the renewable energies sector would generally not have a lower capital requirement than a bank that only finances projects in the fossil fuels sector. This depends, as with all other assets, on the risk.

‘For example, if you lend to a photovoltaic producer who loses the contest and goes bankrupt, you will lose your money. Therefore, the fact that you’re a good citizen lending money to green businesses will not reduce the risk,’ he says, adding:

‘If there’s a wish to push banks in a more sustainable direction, there are much better tools for that purpose than the banking regulatory framework.’

Including non-physical risks

However, even if the ESG profile lacks a direct impact on the risk and the resulting capital requirements, the exposure to green or black assets, respectively, will nonetheless have an indirect effect.

In future publications, the EBA expects to clarify the physical ESG risks, which are now well-defined.

‘Now we see forest fires, risks of droughts, avalanche and flood risks in a European context. I therefore think we are closing in on understanding the different types of the key physical risks we have in the EU,’ says Jacob Gyntelberg.

The non-physical risks, including reputational and judicial appeal risks, he expects to be addressed in future publications, although they are more difficult to quantify.

‘It is clear that banks are putting green labels on more and more products and activities, and it follows that an increasing risk appears to be linked to this due to the volume and due to the possibility that expectations change.’ He adds that it is thus probable that reputational and judicial appeal risks will also be included in the next climate stress test.

‘It would be strange not to do this,’ says Jacob Gyntelberg and continues:

‘We can for example postulate and assume some hypothetical fines, and I believe we will include elements of this. But I do not expect that this will be super sophisticated.’

Developing the model on an ongoing basis

In general, the EBA has chosen a less prescriptive approach and has instead set a more general direction for the sector, says Jacob Gyntelberg.

‘If there is something we think is important, we will clarify to the banks what we expect, which doesn't necessarily require us to be prescriptive. At least not to start with. We will be pragmatic in terms of how we will do it, so it will be a constantly evolving framework,’ he says.

The rationale behind this approach is a recognition that ESG risks and climate change are a strategic challenge instead of a short-term risk for the sector.

‘ESG risks are different from the typical risks we model, where people cannot pay their bills as they have lost their jobs because the economy has stalled. We therefore look at the possibility of using a longer time horizon, which will allow for more adjustments in the banks.’

Upcoming analyses from the EBA will address, among other things, what will happen to the composition of - and the risk in - the banks' lending portfolios when the climate changes. However, there are still many unanswered questions and the data base is still insufficient.

Jacob Gyntelberg compares the situation with the development of the first stress tests in the early 2000s. At that time, there were insufficient data on market and credit risks, but instead of giving up, some general assumptions were formulated that became more sophisticated as the data base was improved.

‘I think we will apply the same approach here. I don't have a fancy presentation and I don't have a finished model to show yet, because it doesn't exist. But that's what we're working on and considering right now.’

The interview was conducted by Simon ​Lund

FinansWatch (Denmark)