Results of the ECB 2022 thematic review on climate-related and environmental risks

The European Central Bank (ECB) has expressed a significant supervisory concern surrounding more than half of supervised banks in terms of the progress made on fulfilling the expectations specified in the Guide on climate-related and environmental risks.

The ECB recently concluded its 2022 thematic review of the banking sector’s alignment with supervisory expectations. This review relates specifically to climate-related and environmental risk management as well as disclosure arrangements.

The ECB has set a remediation timeline for the sector to fully align itself with all expectations by the end of 2024 with a first deadline as early as 31 March 2023. It has also imposed binding qualitative requirements to address severe weaknesses at 30 banks as part of the 2022 Supervisory Review and Evaluation Process (SREP). Concurrently, the ECB published a compendium of good practices from a group of banks that excel in fulfilling its expectations.   

Key takeaways

General

• All significant institutions (SIs) need to be fully aligned with ECB expectations by the end of 2024 at the latest.
• There are three milestones that ECB expects SIs to reach by March 2023, December 2023, and December 2024 (see Table 2).
• Non-compliance with the timelines will affect individual SREP scores and as a result, capital requirements under Pillar 2.
• Advanced practices have been developed by a subset of institutions, including a few less significant and smaller banks. This demonstrates that comparative resource constraints are not an impediment to developing an adequate response to climate and environmental risks.

Materiality assessment

• 80% of SIs reported they are materially exposed to climate-related risks, while the remaining 20% have not performed a comprehensive risk assessment to justify their results.
• Blind spots were identified in 96% of Sis by ECB and were related to SIs not comprehensively considering: i. relevant risk drivers, ii. different time horizons, and iii. exposure to business lines and geographies.
• Quantification of climate risk requires further development, but visible progress has been made in the space of credit risk with 40% of SIs deploying some form of quantification.

Strategy

• There is lack of steering capabilities to implement strategic responses to climate risks.
• Business model risk assessment is still performed insufficiently by most SIs with blind spots around the various time horizons as well as ignored business lines and geographies.
• There is insufficient usage of scenario analysis to test the adequacy of strategic responses.
• In 90% of cases SIs’ strategies do not respond to all material risk exposures.
• SIs take a wait-and-see approach in their strategic responses to climate risks.

Governance and risk appetite

• Almost all SIs have assigned roles and related responsibilities for climate-related risks management body members and/or their sub-committees
• SIs are yet to tackle climate risks in a manner that is granular, organisation-wide, and comprehensive.
• Data collection is a priority for most banks; 80% of SIs managed to perform gap analysis of data availability and IT systems, while 15% have a systematic data collection process.
• Around 70% of SIs provide the management body with information on the impact of climate risks surrounding the business model and risk profiles as part of internal reports.
• SIs set key risk indicators (KRIs) at the highest level of consolidation and do not cascade them down to relevant business lines and portfolios.
• Independent internal reviews of climate risks are rare, as few SIs define the tasks and responsibilities of internal audit.
• Almost 75% of SIs either do not consider climate risks in their remuneration practices or do so in a limited manner without using relevant KPIs.
• In most cases, SIs governance, risk appetite and reporting frameworks do not cover all areas of material risk, leading to a disconnect with materiality assessment.

Risk management

Quantification

• Basic quantification methods to measure climate risks are used by most SIs, with proxies and assumptions used in case of limited data availability.
• Advanced and forward-looking methods are applied by a few SIs; examples of those methods have been shared by ECB in the Good practices on climate-related and environmental risks report.

Capital allocation

• With regards to ICAAP, ~75% of SIs have at least qualitatively described the impact of C&E risks on their capital adequacy.
• A few SIs have used climate scenario analysis to inform economic capital allocation for either credit, market, or operational risk.
• 25% of SIs using the internal ratings-based (RB) approach, include climate risks in the IRB models.

Integration

• The majority of SIs have integrated climate risks into credit-granting and client on-boarding processes, but only a minority integrated it to all stages of the credit risk management cycle.
• Most SIs have integrated climate risk into their frameworks for reputational, liability and/or litigation risks on a high-level basis.
• A few SIs have advanced practices, such as climate value-at-risk or changes in climate-induced mark-to-market, to assess and monitor climate-related market risks.
• A few SIs perform climate-related due diligence of transactions and perform capital adequacy assessment for market risk.
• Most institutions approach the management of other environmental risks in a similar way to climate risks.

Structure of the review

The 2022 thematic review consisted of seven modules, four core and three risk-specific. 186 banks were in the overall scope, of which 107 SIs were under direct ECB supervision and 79 less significant (LSIs) were under national authority supervision.

The core modules applied to all SIs, while the rest applied based on a principle of proportionality and materiality. The review did not cover the ECB’s expectations (the expectations) on stress testing (E13) and disclosures (E12), while expectations with regards to liquidity risks (E12) were only covered to a limited extent.

Table 1. Scope and assessment modules of the 2022 thematic review

Drawing on conclusions from the 2021 Report on the supervisory review of banks’ approaches to manage climate and environmental risks, the ECB decided to enrich the main assessment dimensions of the review for 2. Comprehensiveness, and 3. Effectiveness of practices, in addition to the core dimension, 1. Soundness of practices. In order to perform the assessment, the ECB reviewed the SIs policies and procedures and conducted targeted case assessments.

Each SI received a feedback letter from the ECB, setting out the assessment of the institution’s compliance with the expectations, whilst certain SIs received detailed remediation timelines for achieving full alignment by the end of 2024. The ECB expects SIs to reach a minimum of three milestones (see Table 2. below). The central bank stresses that compliance will be monitored and enforced if necessary and that noncompliance with the milestone deadlines will be considered in the upcoming SREP. Lastly, more than 30 SIs received a qualitative requirement as part of the 2022 SREP, and a few SIs received a lower score under SREP which impacted their Pilar 2 capital requirements.

Table 2. Minimum milestones set by ECB for SIs

Further remarks

SIs have now been advised to work on the specific shortcomings identified by the ECB and deliver in due course, whilst LSIs should follow instructions from the national authorities. The expectation is that national authorities will follow ECB’s requirements and the wider banking industry in Europe will eventually have to comply with expectations set by the ECB. Mazars provides advisor services throughout all stages of regulatory compliance.

References:

Walking the talk – Banks gearing up to manage risks from climate change (europa.eu)