The role of environmental risks in the prudential framework

The European Banking Authority (EBA) is mandated under Article 501c of the Capital Requirements Regulation (CRR), and Article 34 of the Investment Firms Regulation (IFR), to assess whether a dedicated prudential treatment of exposures subject to environmental and/or social risk would be justified. Later, the CRR3 proposal added that the EBA should also assess the prudential treatment of exposures subject to environmental and/or social impacts. In this context, in May 2022 the EBA published a Discussion Paper (DP) which provides an overview of the existing elements of the prudential framework and how they interact with environmental risk, including the specificities for investment firms.

The role of environmental risks in the prudential framework

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Executive summary

The EBA has published a DP on the role of environmental risks in the prudential framework, which assesses the need and justification of potential changes to the prudential Pillar 1 and identifies areas for further work in this respect, focusing on exposures related to assets and activities substantially associated with environmental objectives/impacts. The document also analyses how the prudential framework for investment firms interacts with environmental risk drivers. The feedback, to be submitted by interested parties before 2 August, will be used as an input to the EBA’s work on the reports requested under the CRR and IFR.

Main content

This Technical Note summarizes the main conclusions of the discussion paper on the different elements of the prudential framework: 

• Credit risk:
  • SA approach. External credit assessments are likely over time to incorporate environmental aspects into their underlying methodologies.
  • IRB approach. Need to improve forward-looking modelling and enhancements within the existing Pillar 1 framework preferred vs introducing an environment-related adjustment factor.

As per the collateralized exposures, environmental risks may already be indirectly embedded through the valuation and re-evaluation of collateral.

• Market risk:
  • FRTB SA. Some approaches are described to incorporate environmental risks into the existing FRTB framework. Inclusion of an ESG component in the identification of the appropriate bucket for risk-weighting seems to be more suitable in order to better reflect environmental risks in the sensitivity-based method (SbM). Also, the residual risk add - on framework (RRAO) could be used to capitalise environmental or broader ESG risk.
  • Internal Model Approach. It is considered more pragmatic modelling environmental risks outside the internal model.
• Operational risk. Need to incorporate forward-looking information.
• Concentration risk.  Possibility of introducing a new monitoring and reporting standard to improve the understanding of the size of exposures subject to environmental risks.
• Investment firms.  Interrelations between the IFR and CRR frameworks are highlighted, as well as the importance of taking them into account to ensure consistency and proportionality while addressing environmental risks. The paper analyses analyses how the prudential framework for investment firms interacts with environmental risk drivers in the form of adjusted K‐factors, concluding that in general similar conclusions apply per risk type.

Next Steps

Stakeholders shall provide their feedback by 2 August 2022.

Download the technical note by clicking here.