Topics that keep CROs awake at night – Part 2: The Price Tag of ESG
Frank Elderson of the ECB Board sounds a clear alarm: Neglecting compliance and ethics risks not only undermines sound risk management but also casts doubt on the fitness and propriety of banking leaders. He emphasizes that ESG factors are crucial in modern credit risk management. With ESG expected to be integrated into IFRS 9, impacting both modeling and staging, the cost of risk will rise. Banks failing to comply will face stringent penalties and increased capital requirements.
The year 2024 brought unexpected challenges to banks in the United Kingdom as severe weather events highlighted the urgent need for robust ESG considerations within their risk management frameworks. Events like Storm Henk demonstrated how environmental factors can cause significant collateral damage and elevate the risk of loan defaults by affecting the financial health of borrowers.
ESG Client Rating and Probability of Default (PD)
Integrating ESG considerations—particularly environmental risks—is crucial for accurately assessing and managing credit risk. Banks need to reevaluate factors such as the probability of default (PD) based on potential environmental impacts on their borrowers’ financial stability. These assessments are integral to meeting capital requirements as mandated by regulatory bodies.
Collateral Value ESG Haircuts and LGD
The evaluation of collateral values must also consider potential environmental impacts, requiring banks to apply ‘ESG haircuts’ to these values. This adjustment reflects the increased risk and potential devaluation due to environmental factors, which in turn affects the calculation of loss given default (LGD). These recalculations directly influence the overall cost of risk.
Failing to adequately manage C&E risks is no longer compatible with sound risk management. Such a failure also increasingly calls into question the fitness and propriety of those in charge of establishing and steering banks’ practices.
Frank Elderson, ECB Board Member
Navigating ESG
ESG (Environmental, Social, and Governance) transitional risks involve the challenges of shifting towards sustainable business models or adapting to changes in ESG-related regulations, technology, or consumer preferences.
These risks stem from:
- Regulatory changes: Adapting to policies for a low-carbon economy can affect business operations and supply chains.
- Technological changes: Investing in new technologies to cut emissions or enhance energy efficiency may disrupt current business models.
- Market shifts: Evolving consumer preferences for sustainable products can impact demand and alter competitive landscapes.
- Physical risks: Including extreme weather and resource shortages, which can disrupt operations and assets.
Effective management of ESG transitional risks requires scenario analysis, stress testing, and incorporating ESG considerations into decision-making.
ECB’s Stance on ESG Risk Management
According to Frank Elderson, the banking industry’s response to environmental risks is often too slow. He emphasizes that “climate and environmental risks are immediate financial threats that require urgent and thorough integration into bank risk management practices.” Banks that fail to meet these requirements face significant penalties, underscoring the regulatory push for proactive ESG risk management.
Role of Digital Solutions in Modern Risk Management
One thing is certain: The cost of risk will increase for banks that are not addressing ESG concerns; however, for some banks with a sound approach, costs can actually decrease.
Adopting advanced digital tools is essential for banks to effectively manage ESG risks within the framework of a Unified BCBS 239 Risk Data Management. These tools enable real-time data analysis and dynamic adjustments to risk models, helping banks respond quickly to changes in environmental conditions and other ESG factors. Such technological advancements are crucial for compliance, operational resilience, and strategic foresight.