What’s going to happen next is more important than what’s already occurred

• BlackRock’s study on behalf of the European Commission dug deep into how banks were responding to ESG risks
• Divisions remain between how regulators, financial institutions & civil society view banks’ ESG priority setting process
• The most important need for banks to change is their perspective so they begin to look at ESG risk management differently than they see financial risk management

A long-awaited study commissioned by the European Union has found that banks faced significant challenges in how far they have gone in considering environmental, social and governance (ESG) integration. The study — conducted by BlackRock — interviewed a wide range of European financial sector stakeholders, and consequently represents many perspectives that are not always in alignment. The report’s conclusions, while focused on Europe, bring global relevance, especially to countries with less institutional development on ESG integration, where the challenges highlighted are starker.

One of the most important of the report’s conclusions is that, notwithstanding the importance of improving data accessibility by and for banks’ risk management purposes, and that of supervisors, it doesn’t allow the perfect to become the enemy of the good. This reiterates a similar message highlighted in the European Banking Supervision report we described last week.

The analysis from BlackRock puts it in a similarly clear way and reiterates the call to action:

“Although the importance of ESG-related data has been widely recognised, banks should make significant efforts to enhance data quality, availability and comparability, as well as infrastructure improvements. This would further support banks’ efforts to adequately measure ESG risks and integrate them within their risk processes. Data limitations should not be a rationale to defer taking immediate action. Banks can develop interim proxies, and additional ESG data can be sourced from third parties and through client questionnaires. These exercises should be supported by supervisors.” [Emphasis added]

The report outlines some of the areas where significant challenges remain, with some suggestions on how to solve them. One of the most critical gaps between financial sector stakeholders is a lack of agreement on what banks should do themselves, what regulators should require, and the breadth of how ESG issues affect banks.

By and large, civil society organizations have advocated that ESG reporting and integration into financial & investment decisions should consider ‘double materiality’ (financial impact to banks and impact of their financing on others), while regulators pay much more attention to financial materiality for the financial institutions. Banks have generally acknowledged that ESG risks affect them in many ways, not only through traditional sources of financial risk.

For example, by financing projects that have adverse environmental or social impacts, banks can suffer significant reputational risk. Even where this reputational risk doesn’t create measurable adverse financial impact in the short-term, or where it fails to show decisive evidence of systemic risk, it does create risks that can impact a bank’s standing with customers and employees and have impacts on shareholders.

The gap that often emerges between regulators, banks and civil society is how to view and respond to these types of risks. BlackRock’s study concludes that while civil society organizations want definitive action from regulators through changing capital adequacy rules (Pillar 1) or imposing new reporting requirements (Pillar 3), regulators have been more hesitant.

On some issues such as climate change, there is some urgency around financial stability concerns relating to climate change. However, regulators are pursuing less prescriptive approaches, starting with Pillar 2 supervisory reviews, while they see enough evidence that specific climate or ESG risks can be found to affect financial performance of specific loans through traditional metrics such as increasing the probability of default and higher realized losses.

For the time being, banks have made changes in relation to some ESG risks where they see the writing on the wall from regulators, or in their financing of specific sectors with particularly high-risk characteristics, such as coal. Although they acknowledge a broader concern beyond just financial risk, the way regulators view it, the slow pace of change among regulators is favorable because it allows the wait-and-see approach buffered by real and consequential data availability gaps.

These contours are found well beyond Europe, and can inform the current state of responsible finance adoption in banking systems even in more developed markets. They can be seen as well in emerging markets where regulatory capacity is often more limited, civil society organizations may be less influential, and banks are more content to remain operating in familiar ways. The status quo of banking is firmly embedded globally and it takes a lot — for example, a global pandemic and rapid acceleration in seeing the physical impacts of climate change — to move action quickly.

Yet that is all in the past — it informs where we are today but not necessarily where we’ll go next year or in the years that follow. One of the principal conclusions of the report was that study participants called for a new way of thinking about risk management. On the issue of supporting or penalizing factors that lower or increase risk weighting of financing depending on how sustainable it is, a limiting factor for regulators is a lack of historical evidence on differences in performance between sustainable or unsustainable loans.

The study participants wanted a much more forward-looking and adaptable — dynamic — response to ESG risks. BlackRock explained that participants said: “Stress testing and scenario analysis should form a core component of banks’ and supervisors’ ESG risk measurement, especially for climate-related risk. The number of scenarios should be increased, and scenarios should be sufficiently ambitious and granular in order to standardise approaches and enhance comparability of results. Regardless of involvement in supervisory exercises, banks should conduct internal climate scenario analysis to deepen their understanding of climate-related risks.”

There’s a lot of work to reach the point where comparable and standardized stress testing and scenario analysis can be completed on climate change, let alone other ESG issues. Despite the differences in preferred approaches — whether regulatory-led and prescriptive, selective regulatory interventions when financial stability is impacted, or more gradual and market led — there is a common recognition of the importance of ESG and climate risks to banking. The bottom line is that it’s important to take action, as well as share experiences so that every new approach can inform development for other institutions, rather than letting everyone move forward with their own trials and errors.

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