Financial sector regulators’​ policy changes are echoing around the globe

• European Banking Supervision signals that the clock is ticking on their integration of climate & environment risk
• Regulatory warning of consequences for ‘outliers’ who don’t integrate climate risk have similar messages internationally
• Regulators expect action even amidst uncertainty, and financial institutions are expected to find ways to act with the data they have

European financial institutions’ approach to climate and environmental (C&E) risks are often seen as world-leading, yet many European banks are lagging behind where they need to be on C&E risks, according to a recent study by the European Central Bank’s Banking Supervision department.

One area where banks are lagging is in integrating C&E risks in their credit risk assessments, which more than 60% of banks don’t expect to be completed by the end of 2022. For those integrating C&E risks, the highest proportion (nearly half) of banks have integrated into lending practices and client due diligence. The shares of banks integrating C&E risks into risk classification, credit portfolio analysis and loan pricing are far smaller and adopted in fewer than one-in-four European banks.

This is a useful benchmark for other markets where responsible finance practices — especially consideration of climate-related financial risk — by financial institutions are at an earlier stage of implementation. On issues such as climate and biodiversity risk, regulators are working together to improve their skills and they are cross-pollinating their knowledge as they assess the risks that the financial institutions they regulate face.

The ECB has come out clearly in stating the importance of climate-related risks and will hire a dedicated climate scientist. ECB President Christine Lagarde explained in July that “climate change has consequences for us as a central bank pursuing our primary mandate of price stability, and our other areas of competence, including financial stability and banking supervision”. The Banking Supervision newsletter explains that the ECB “will also give greater prominence to environmental risks beyond climate-related risks, such as risks of biodiversity loss and pollution. First indications show that these risks are of a similar magnitude to climate-related risks.”

Other regulators working through the Network for Greening the Financial System (NGFS) are likely to follow the lead of the ECB on climate-risk management in the banking system, and some already have. For example, Bank Negara Malaysia Governor Nor Shamsiah Mohd Yunus announced in June preparations towards mandatory disclosure of climate-related financial risk by financial institutions in the coming years.

The ECB’s approach involves analyzing risks and risk management such as in the survey mentioned above, but it also involves some ‘sticks’ along with the positive guidance and reinforcement. The ECB Banking Supervision newsletter explains that “where banks are extreme outliers, the ECB will impose a qualitative supervisory measure as part of the 2021 Supervisory Review and Evaluation Process”.

This is similar to Nor Shamsiah’s warning that “[Bank Negara] is exploring various options to encourage better risk management approaches by outlier institutions, including through Pillar 2 capital requirements and supervisory assessments to reflect an inadequate consideration of climate risks”.

Regulators are getting on the same page on climate-related risks, and all indications are that biodiversity risk management won’t be far behind and is likely to move at an even more rapid pace. Banks and other financial institutions have a long list of concerns to tackle in responsible finance, but easy excuses for inaction are likely to fall upon increasingly deaf ears.

ECB Banking Supervision takes an increasingly urgent tone under the heading “Banks need to speed up their efforts”, writing: “It is clear that many bank practices will not meet the supervisory expectations in the near future. This is rather alarming as banks are crucial to financial stability, so their strategies, risk management and disclosure arrangements need to be sound. The ECB expects banks to adequately manage C&E risks in a timely fashion.” [emphasis added].

The ECB acknowledges the challenges to banks adopting C&E risk management practices, noting that “the ECB is aware that data and methodological gaps may make it difficult to fully implement the supervisory expectations in some cases. Here, the ECB encourages banks to adopt a strategic approach and to take intermediate steps as appropriate.”

Yet it comes across as a nudge towards some action rather than waiting on regulatory mandate. It is followed by examples of good practices, like for banks to set up committees with finite timeframes for setting plans into motion, to conduct gap analysis to guide implementation, and for the use of proxy data or qualitative data where quantitative data aren’t available, including creating heat maps to prioritize actions. Regulators are in motion; they are saying it’s time for action.

Republished from the RFI Foundation’s weekly newsletter. Subscribe for free here!