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Regulatory Briefing: EBA asks about social factors, double materiality

By Victor Smart

The European Banking Authority has opened a consultation on what factors should be added to regulators’ prudential frameworks for financial institutions. Should the ‘social’ aspect of ESG be considered? What about the concept of ‘double materiality’? Given the increasing severity and frequency of physical environmental events, should a forward-looking risk analysis be included? 

These specific questions are part of an EBA discussion paper, ‘The Role of Environmental Risks in the Prudential Framework’, which is designed to explore how environmental risks should be incorporated into the Pillar 1 prudential framework (on the minimum capital that all banks are legally required to hold).

The wide-ranging document says that climate change and broader environmental issues will become even more prominent, and it asks frankly whether the prudential framework can sufficiently account for these new risks. One aim is to explore whether there is the necessity for a dedicated prudential treatment of “exposures substantially associated with environmental and/or social objectives and those subject to environmental and/or social impacts.”

In the EBA’s words: “When considering the introduction of a dedicated treatment of environmental risk drivers, one first needs to evaluate the extent to which these are already reflected in the prudential framework. To the extent that environmental risks are already captured in the prudential framework, any further adjustment should be designed in a way that avoids double counting, to ensure the framework’s consistency and robustness. In light of the expectation that environmental risks will induce higher and potentially more extreme losses than in the past, questions also arise as to whether the framework can capture these risks appropriately and whether capital requirements might be underestimated.”

Wide-ranging, open-minded. The EBA paper is not just wide-ranging but also, on the face of it, surprisingly open-minded as it considers social aspects, which wouldn’t traditionally and directly be addressed by a banking regulator. Then there is the challenging issue of double materiality. This would require a financial institution to explain not only the risks and opportunities it might face from changes in the environment and society, but also the effect on both of these areas of its own actions. The proposed European Sustainability Reporting Standards part of the EU’s Corporate Sustainability Reporting Directive, which will capture financial services firms, has embraced the double materiality principle.

Meanwhile, the prudential framework has historically been built on backward-looking risk assessments. This, says the EBA, does not align well with the forward-looking nature of environmental risks. But, again, moving towards a forward-focused analysis could be contentious.

Submissions may be made until 2 August.

 

A service from the Financial Times