Banking Regulation and Risks

#### **Chapter 4**

## Banking Regulation for ESG Principles and Climate Risk

*Rosaria Cerrone*

#### **Abstract**

Nowadays banking activity is greatly influenced by environmental and social conditions. For this reason, regulators have been committed to defining Environment, Social, and Governance (ESG) principles. In addition, climate change has shown the relevance of climate risks that have relevant implications in the new risk management process. The 2030 Agenda for Sustainable Development is based on the 17 SDGs that are, in the next future, the main challenge for the worldwide economy as they will be the basis for real sustainable activities. In this context, banks play a very relevant role as they have the power to lead this new challenge and are able to facilitate businesses to run toward a sustainable green economy. For this reason, banks' activity is now oriented to increase and allocate credit and investment to more sustainable sectors. As climate risk is, at the same time, cause and effect for a socially responsible activity, regulators have been considering the role of banks for the green and ecological transition, which is necessary to face this new risk. The chapter is an overview of rules, regulations, and guidelines for banks referred to ESG principles and their adoption in a global perspective; it also refers to climate risk that, due to its components, may require further capital to preserve banks' stability.

**Keywords:** climate risk, climate change, ESG, environmental sustainability, sustainability risk, sustainable finance

#### **1. Introduction**

The chapter describes the change of banking regulation toward governance and environmental sustainability challenges. It shows that it has not been fully understood how these new types of environmental and social risks affect differently banking activity. As risks are global and systemic, it is necessary regulatory coordination. The main international and European initiative to assess the relevance of environmental climate risks for banking regulation considers some banking policy recommendations for countries to coordinate their regulatory actions. This is due to the fact that banks play a crucial role in providing credit and financial resources that can be used to mitigate the negative effects of environmental risks enabling the economy to become more resilient.

Regulators are now aware that there are linkages between natural disasters and financial market instability. In fact, climate change could potentially threaten financial resilience in general and economic prosperity over the longer term.

#### *Banking and Accounting Issues*

In recent times, the frequency and intensity of natural disasters have increased, causing much greater damage to economies. The negative effects are not only physical and material, but they can lead to high loan losses and provisioning for banks located in those areas with hard difficulties.

The main environmental risks create potentially negative externalities for the banking sector and for this reason banks are analyzing these risks and are putting them into their risk management models and governance frameworks.

By affording these challenges, banks also play an important role in supporting the economy's adaptation to environmental changes and in creating financial resilience to environmental risks. For this reason, new loan policies are devoted to reallocating credit to more sustainable sectors of the economy; by doing so banks contribute to reducing environmental sustainability risks, mitigating their impact.

Banks are facing these risks by adopting different types of green banking practices. These practices are referred to as the option of the ESG guidelines with a particular focus on risk management in the area of project finance and the allocation of credit to renewable energy resources. Other practices are specifically positioned to mobilize capital to the green economy, including renewable and clean energy projects by making loans and investments, and structuring specialized transactions [1].

Banks are facing new challenges. For this reason the European regulatory framework for sustainable finance has greatly developed. European leadership in sustainable finance has given rise to several regulations. In particular, banks will consider the CRR Pillar 3 and EU taxonomy disclosures, also because EBA is also aligning its position to this view.

The structural shift toward the green transition and the climate crisis is exposing banks to physical and transition risks, which they need to be ready to manage. Banks will need to strengthen their risk management frameworks and reassess their business strategies. A recent ECB assessment shows that banks have made some progress in adapting their practices to manage these risks, but none are close to meeting the supervisory expectations [2]. For this reason, supervisors have already planned a number of specific measures for next years and beyond, including a thematic review of banks' environmental risk management practices and a stress test on climaterelated risks. Many of the proposed regulatory changes actually stem from research conducted by the European Banking Authority and the ECB and are focused on issues identified in the use of internal models by European banks. The chapter is structured with paragraph 2 that describes the relevance of ESG principles in the banking and financial sector and the source of ESG risks, with particular relevance for climaterelated risk; paragraph 3 focuses on the difficulties of regulators to define so new rules and guidelines to define new strategies to control these new risks; paragraph 4 concludes the chapter pointing out the main policy implications of this new era for banks and financial institutions.

#### **2. ESG principle in the financial sector**

During the last years banking and financial sector has been involved in a great change, which has been characterized by the introduction of the new principles of Environmental Social and Governance (ESG). These principles are forcing banks toward an innovative vision of management both internal and external. It is known that there is a wide interpretation of the meaning of the ESG principles. In general,

#### *Banking Regulation for ESG Principles and Climate Risk DOI: http://dx.doi.org/10.5772/intechopen.104110*

banks are becoming more and more active in investment and asset allocation, and in new business models as well. The attention to the environment and its exploitation, to the reduction of pollution or carbon emissions, are influencing their choices and strategies. New attention to social justice and social principles are very relevant so new governmental bodies are under control. The final goal is a more sustainable framework for financial activity with a selection of assets and sectors to finance.

The first step toward sustainable finance was the Action Plan of Financing Sustainable Growth, which was published in 2018 by the European Commission. The regulatory framework began to be defined to give banks and financial institutions a new scheme that granted the real development of innovative strategies about the introduction of sustainability principles as the basis for new growth of the financial system.

Beyond EC's Action Plan there was EBA's Plan which gave other guidelines to banks and rules about the adoption of ESG principles. In particular, it became necessary for regulators to implement ESG principles in their rules for the financial sector.

The definition of a complete framework of ESG principles is very important but it is still long to be completed; anyway it is important to reach a full acceptance and a full change toward sustainable finance.

The ESG principles are tied with the 2030 United Nations Sustainable Development Goals (SDG) agenda that considers environmental challenges, including climate change, as a major concern to the stability of the global economy. The most important step toward the control of the climate risk was the Paris Agreement was adopted in 2015 to strengthen the global response to the threat of climate change. Financial policy and regulation are increasingly recognized as important for managing the transition toward a more environmentally sustainable economy. The evolution to a more sustainable economy requires the adoption of new paradigms and the green guidelines in lending activity to reach a better selection of economic activities to finance [1]. At the same time, governmental or regulatory intervention is necessary to guide the banking sector in allocating more credit and investment to sustainable activity and in protecting the economy against related financial risks. The role of financial regulation in supporting the transition to a more sustainable economic path has been deemed critical by international organizations. The definition of ESG factors is not simple or easy also because there are a number of guidelines and rules formulated by various institutions. **Table 1** presents the existing frameworks currently used by international institutions.

In **Table 1**, if one considers the frameworks addressing ESG factors, it can be noticed that the idea to have a wider vision of the factors different from the economic and financial ones, begins in 2003 with the Equator Principles that induce banks to consider and measure environmental and social risks in lending activity. The most recent Principles of UNEP FI are specifically devoted to the adoption of SDGs and the Paris Agreement in banking activity.

Guidelines, frameworks, and principles try to offer a multi-layer dimension of ESG factors. This effort is due to regulators' position to recognize the relevance of these aspects for banks and to induce their choices and managerial strategies.

As concerns the environmental factors international institutions and authorities are working in recent times. It consists of guidelines and best practices proposed as suggestions to banks and financial institutions. These guidelines are important because they are the first step to having a uniform discipline about sustainable finance and green financial assets. On the basis of these initial definitions, banks and financial institutions must face new risks deriving from these factors that should be considered in financial management and the financial markets.



#### **Table 1.**

*International frameworks and standards defining ESG factors.*

#### **2.1 ESG risks: relevance and assessment**

ESG factors are characterizing the definition of new strategies for banks and financial institutions. This paragraph starts from EBA's definition of ESG risks and shows some considerations about their evaluation and management.

According to EBA [3] "*ESG factors are environmental, social or governance matters that may have a positive or negative impact on the financial performance or solvency of an entity, sovereign or individual*."

These risks may have different and typical features, due to their main causes and effects. ESG risks influence banking activity both in lending and in asset class allocation. For this reason, banks must classify ESG risks. By doing they must consider separately the three factors, Environmental, Social, and Governance. As concerns environmental risks, which are caused by a number of factors, banks must face both their physical impact and the effects of transition, as it is specifically happening in the so-called "green transition." Social risks are caused by the diffusion of social inequality, health troubles, or the exploitation of human labor. The governance risks are important as well; and for example they are caused by corruption or similar in the board of directors of the company.

This complex articulation of such risks imposes banks to become more selective in their activity. Moreover, these risks are also more difficult to be measured as they are mainly focused on subjective elements and all quantitative indicators are still to be defined. For this reason, ESG risks are considered systemic and can impact the financial system as a whole. Institutions need to build their resilience to ESG risks across different time horizons, by taking a comprehensive and forward-looking view, as well as early and proactive actions, under supervisory control.

According to EBA, it is necessary to include ESG risks into the banking regulatory and supervisory framework, giving a particular emphasis on climate and environmental risks although social and governance risks are already important and necessitate attention. The main attention to these risks is due to the fact that they seem to

be the most relevant because of climate change and the governments' requirements to move toward "green economy" by converting the "brown business."

To manage these risks, their transmission channels must be considered and incorporated into disclosures, risk management, and supervision. ESG disclosure is very relevant for stakeholders interested in assessing banks' risks and their sustainable finance strategy [3]. This is why the Basel Third Pillar must be integrated and the non-financial reporting is linked to this need.

The analysis of ESG risks is very important because it is considered by supervisors as the new frontier to reach a resilient business model and risk management system to ensure banks' preparedness for ESG-related challenges. ESG risks-related considerations must be fully taken into account in the definition of strategies and objectives, as the same must be done integrating ESG risks in governance structures, and managing these risks as drivers of financial risks. The actual regulatory framework is based on these actions expected by banks and the new supervisory and evaluation process (SREP) will be performed including these risks [2].

The materialization of ESG factors has consequences on banks' performance because it is linked to all financial risks, such as credit, market, operational, liquidity, and funding risks. In general, we can maintain that ESG risks can be defined as the negative materialization of ESG factors through their counterparties or invested assets [3]. For example, if a bank grants a loan to a company that is suffering under the transition risk and costs of a green economy, its difficulties will influence the bank's credit position and credit risk. This happens because this company will have problems in loan repayment and reimbursement due to the high expenses caused by the transition itself.

It is evident that ESG risks must be considered under a double perspective, proposed by EBA as an outside-in and inside-out perspective. According to the first dimension, banks can be impacted by ESG risks through their counterparties and invested assets, but at the same time, they may be impacted by or have an impact on (inside-out perspective) ESG factors. Even if both perspectives are important, the inside-out becomes much more relevant. The relationship between the inside-out and outside-in perspective is explained by the double materiality, which is divided into financial materiality and environmental and social materiality.

The double materiality implies that banks must measure and evaluate both the internal choices and the influence of the external behavior of companies and clients referring to ESG factors. The financial materiality can be explained by considering the effects on the company's economic and financial activities. The environmental and social materiality refers to the influence of the above-mentioned company's economic and financial activities on ESG factors themselves. With a circular process, this influence may cause, at the same time, financial materiality.

The assessment of ESG risks is done using three different methods—portfolio alignment method, risk framework method, and exposure method.

At the core of the portfolio alignment method, there is the meaning of alignment. According to this method banks, investors and supervisors will consider how far portfolios are aligned with globally agreed targets. This method could mainly be used for strategic purposes rather than risk management purposes because it does not explain the link between the global targets and the risk indicators of the bank.

The risk framework method includes the climate-stress test. This method is particularly relevant for climate risk, which is a forward-looking risk and stress testing over a future time horizon is, therefore, a useful tool for modeling climate risk impacts. On the contrary, the other ESG risks are in general more backward-looking.

#### *Banking Regulation for ESG Principles and Climate Risk DOI: http://dx.doi.org/10.5772/intechopen.104110*

The risk framework method focuses on the sensitivity of portfolios and the impact that climate change has on the real risk of the exposures. The actions to face the risk are derived from the level of measured sensitivity or direct risk of losses considering the current level of environmental factors (or climate factors, more specifically) and the possible developments under the selected scenario. The application of this method brings to a risk-based adjusted portfolio in the medium-long term and makes it possible to consider also internal components of banking and trading book.

An exposure method is a tool that banks can apply directly to the assessment of individual counterparties and individual exposures, even in isolation. This method is based on a direct evaluation of the performance of exposure in terms of its ESG attributes. This method can be used to complement the standard assessment of financial risk categories. Thanks to this approach, there is a calibration at the specific company level. It is possible to put in evidence the specific sensitivities to ESG factors of different segments and sub-segments of economic activity. This method suits well to all three aspects of ESG.

This method is considered the most suitable if compared with the others. Even if it is not based on complex scenario analysis, it considers backward-looking metrics and makes banks able to classify their ESG risks' exposures. This method gives banks the possibility to take adequate decisions to face ESG risks. The exposure method has developed some methodologies that can bring to ESG risks measurement. Regulators classify them in the following four methodologies—a. ESG ratings provided by specialized rating agencies; b. ESG evaluations provided by credit rating agencies; c. ESG evaluation models developed by banks in-house for their own assessment; and d. ESG scoring models developed by asset managers and data providers.

With the first methodology ESG ratings are provided by specialized rating agencies. They are stand-alone ratings on ESG factors, and consider the risk exposure to ESG factors. Rating agencies consider also the ability of the management to afford risks and to catch opportunities. These methodologies are generally built on a quantitative analysis of key issues identified for each company, but they also consider qualitative information collected by analysts from public information and engagement with companies.

In the case of ESG evaluations provided by credit rating agencies (e.g., S&P ESG), these evaluations integrate ESG factors into the standard credit analysis. They measure how ESG factors affect both certain scorecard components such as cash flows and leverage, and elements outside of the scorecard. They contribute to giving additional input to the existing financial risk assessment. Anyway, some difficulties in comparing ESG ratings by different providers are present as they include the different weights applied to the individual elements of ESG factors.

The internal methodologies have been developed by larger banks that were organizing their information systems on the basis of internal data deriving from wide data sets concerning their customers. These are internal and need the validation of regulatory authorities to be compliant with the existing rules. Finally, the ESG scoring models developed by asset managers and data providers, are publicly available.

Even if there are a number of methodologies, they are still improving both by banks and by regulators and they can be still considered at the early stages of development. These methods are very different both for the factors that are considered and for the results. They also differ for time horizons and for these reasons banks are experimenting with them all on different basis and portfolios. Anyway, the exposure origination is very important because it shows the future composition of a bank's portfolio and signals to counterparties, investors, and wider market participants that

investments are no longer sustainable and supported by the financial sector. This is true and relevant because the EBA Guidelines on Loan Origination and Monitoring are oriented to consider ESG factors as taken into account in banks' credit risk appetite, policies and procedures.

The analysis of ESG risks requires a real ESG disclosure; this means that banks must map all business units and divisions on the basis of ESG risks' framework and above all on the basis of the inside-out and outside-in perspective.

This mapping is finalized to manage the risk of conflicting or inconsistent information being disclosed; to ensure consistency and/or alignment of the disclosure; and to identify the overlaps in the reporting pillars where common reporting metrics can be considered. This kind of risk disclosure is important as it is the expression of internal analysis and mapping of ESG risks, which must be constantly monitored in the next future. This mapping can be considered as an absolute improvement of Basel Third Pillar.

#### **2.2 Climate-related risks**

The environmental aspect is really important as it is considered as the core for climate risk. Climate risk has a double dimension; in fact, banks and financial institutions are both impacted by and contribute to climate risks. For this reason, regulators are prioritizing appropriate climate risk disclosures as part of ensuring the broader transition of the financial industry to more sustainable, and positively impactful business models. According to the Financial Stability Board [4], climate risk must be considered by banks as physical risk and transition risk.

Physical risk is *the possibility that the economic costs of the increasing severity and frequency of climate-change-related extreme weather events, as well as more gradual changes in climate, might erode the value of financial assets, and/or increase liabilities* [4]. It is evident from the definition that physical risk is based on the effects of extreme weather events that have physical consequences leading to damage to the value of financial assets or collateral held by banks. This may also imply an increase in credit risk because companies have their assets and properties destroyed becoming unable to pay or banks have investments in financial assets of the same companies.

Transition risk *relates to the process of adjustment toward a low-carbon economy. Whilst such an adjustment may be a necessary part of the global economy's response to climate change, shifts in policies designed to mitigate and adapt to climate change could affect the value of financial assets and liabilities* [4]. This risk puts in evidence the broader economic adjustment toward a low-carbon economy with the presence of a range of other factors, such as the emergence of disruptive technology.

Many stakeholders are interested in these two dimensions of climate risk and want to understand banks' strategies in financing the transition to a zero-carbon economy. Under EBA's requirement banks are required to disclose information on climate risks, mitigation action, and green asset ratio [5].

The disclosure about climate risks is due to the fact that according to EBA it is important to put in evidence how climate change may reinforce and worsen other risks in banks' balance sheets. Concerning mitigating actions banks must inform about what they have in place to address those risks including financing activities that reduce carbon emissions.

With the Green Asset Ratio, it is possible to understand how institutions are financing activities that will meet the publicly agreed Paris agreement objectives of climate change mitigation and adaptation based on the EU taxonomy of green

#### *Banking Regulation for ESG Principles and Climate Risk DOI: http://dx.doi.org/10.5772/intechopen.104110*

activities. The Green Asset Ratio is based on the EU taxonomy. It is a measure of the financial support that banks are willing to give to sustainable activities. Through this ratio, it is possible to put in evidence the assets that can be considered environmentally sustainable as they are referred to grant finance to activities of climate change mitigation on climate change adaptation. It is important in setting strategies, and even a bank with a low Green Asset Ratio can identify how it wants to change its financing activities over time to meet the Paris agreement objectives and measures. It gives information about a strategy that must be monitored. It is expected by EBA to receive from counterparties subject to NFRD disclosure obligations reliable data for the Green Asset Ratio from December 2022, developing a framework that identifies the required disclosure standards and their materiality triggers. The most commonly referenced framework in the case of climate disclosures is the TCFD framework, which is recognized by regulators in the EU and is considered as guidance on climaterelated disclosures.

Banks and financial institutions are exposed to climate-related risks through both their own operational impacts and the activities of their borrowers, customers, or counterparties. According to the outside-in and inside-out approaches, banks that provide loans or trade the securities of companies with direct exposure to climate-related risks suffer and accumulate climate-related risks via their credit and equity operations. In addition, as the markets for lower-carbon and energy-efficient alternatives grow, firms may assume material exposures in their lending and investment businesses.

The ECB Guide [5] represents a shared document that shows how relevant are a disclosed analysis of such risks to grant that banks are managed in a sound and safe way. The relevance of climate-related risks is really great and the ECB has declared that banks conducted a self-assessment in light of the supervisory expectations outlined in the guide and to draw up action plans on that basis. The self-assessment plans will be considered by ECB as the first step toward more accurate monitoring of climate risk among all typical financial risks. This importance is also evident in the declaration of the climate-related risks stress test that will be run by ECB during this year.

#### *2.2.1 Physical risks*

As it has been described above, physical risks are specifically referred to as natural catastrophes and the economic losses caused by them; and this situation has increased in the last decades. The number of some types of extreme weather events has globally increased. Such events have become more likely or more severe due to the effects of climate change, and it is known that further warming will intensify them and consequently the negative effects at the basis of the increase of climate risk.

Physical risks include losses stemming from changes in physical capital because natural disasters destroy infrastructure and divert resources toward reconstruction and replacement. These risks affect also human capital, through deterioration in health and living conditions. The hard conditions due to the physical risks may have consequences on future expectations with a reduction of investment, given the prevailing uncertainty about future demand and growth prospects.

If there is no action to reduce the effects of climate change, physical risks will continue to increase in the future. The frequency and severity of extreme weather events might increase non-linearly and become increasingly correlated with each other over time. The consequences of physical risks can affect mainly market and credit risks.

The climate risk consequences may influence the value of financial assets causing losses for banks, investors, and financial institutions. The losses are the expression

of market risk, but they are not directly caused by negative movement of financial variables (i.e., interest rates or assets prices), instead, their origin is connected with the losses due to the material destruction due to physical risk. As concerns credit risk it is almost easier to be understood as it is the consequence of the impossibility to repay and/or to reimburse loans, because of the physical destruction of assets, things, or the death of human beings. It is evident that banks are in presence of a large and composite number of risks and aspects of the same risk [4].

The impact of physical risk is not easy to be estimated with the effect on a bank's assets. Estimates are based on a number of assumptions and subject to numerous sources of uncertainty concerning the global emissions with the potential increases in global temperatures and the severity of extreme weather events. So, the macroeconomic scenario and the variation in financial assets value are highly uncertain. Finally, there are the uncertainties associated with the future path of climate change and its impact on asset prices. Heating temperatures are increasing climate risk and physical risk in particular. They seem to be unavoidable, and this will cause an increase of negative effects on the financial system and assets prices [6, 7]. As physical risks are different in the sector and geographical areas, market and credit risks may be affected by these differences. This condition reinforces the situation in which other differences and in particular significant losses derive also from the disruption at the national level, and concentrated in certain countries with and exposure to operational risks that could disrupt firms' operations, and affect other firms (financial and non-financial) provided by banks' financial services amplifying risks for financial stability.

#### *2.2.2 Transition risks*

It is known the necessity of bringing the temperature to be below 2° C above pre-industrial level. Transition risks stem from the possible process of adjustment to a low carbon economy, and its possible effects are expected on the value of financial assets and liabilities. Such a transition to a low carbon economy would imply significant structural changes to the economy, including a major reallocation of investment. This could have a significant impact on firms involved in the production of fossil fuels, as well as other sectors whose business models rely on using such fossil fuels or that are energy intensive. The effect changes in asset prices with consequences on banks' portfolios. These prospective effects might have also the consequence of reallocating financial resources from highly risky sectors or businesses tied, for example, in fossil fuels to new and less pollutant activities, by doing so supporting a real transition to a green economy. We can affirm that there will be a transformation of banks' strategies and the support of market segments devoted to new and more sustainable sectors. We can say that the transition risks represent the lever to accelerate banks' contribution to a renewal of economy and financial flows besides the real beginning of sustainable finance. On the contrary, a disorderly transition to a low-carbon economy, unanticipated by market participants, could have a destabilizing effect on the financial system. The most relevant effect will be an increase in credit risk due to the instability of such companies operating in brown sectors and receiving loans from banks. A transition to a low-carbon economy might reduce some borrowers' capacity to generate sufficient income to service and repay their debts [8]. From this situation, banks are forced to face a higher credit risk, which is the result of a double scenario. The former is connected to the well-known difficulties in payments, and the latter is the increasing risks connected with the reduction of collateral value [7]. Transition scenarios are not able to catch all policy,

technology and/or consumer preferences they change very rapidly. Moreover firms' vulnerability to transition risks isn't easy to be evaluated; in fact it is not only due to the firms' operations, but also to their suppliers and customers.

#### **3. Banking regulation**

Since time regulators are exploring this kind of risk and its widespread and are also analyzing possible ways to reduce them. However, the control of climate and ESG risks is at an early stage [9–11]. In the Appendices at the end of the chapter, there are the main initiatives that show the timeline and the complexity of the regulators' activity with regard to ESG disclosure, climate risk analysis, and reporting for banks.

In this context, financial regulators are defining the principles about which climate risks are managed by banks. This interest derives from the necessity to reduce their impact both for banks themselves and for the financial system as a whole. Supervisory expectations aim at covering some institutional risk management elements (i.e., governance, strategy, scenario analysis, and/or risk management) and some financial standard-setting bodies are also starting to work on supervisory guidance related to climate risk. In fact, till now climate risks are considered as the worst for financial stability.

For example, scenario analysis can be used to quantify the totality of exposures of banks to climate-related risks within their framework and this is also called "climate stress test" [5]. There is also a significant approach to consider macro-prudential policies to mitigate climate risks to save the stability of the financial system, by giving banks a major resilience.

A large number of guidelines, best practices, and notices are the evidence that banking regulation shows a kind of difficulties to make a unitary proposal. As it has been said climate risk has a "liquid" structure that makes it really complex for banks to define their ambits and strategies.

#### **3.1 Banking supervision and ESG factors**

The further evolution is the complete introduction of the ESG factors and ESG risks in the supervisory process and all control systems. These risks are not yet explicitly included in the CRD, the IFD, or in the SREP guidelines; at the same time, the consideration of these factors by supervisory authorities should be made with respect to the principle of proportionality, that links the conditions of each bank and its exposure to risks specifically referred to their dimension, context, and background [3].

Any way the integration of ESG risks into the supervisory review will be implemented gradually, considering the development of the related methodologies for the qualitative and quantitative assessment of ESG risks. The first step is the integration of these factors in the strategies and policies adopted by banks, with an improvement of the corporate and risk culture, and of the risk management frameworks. Only after the initial period when ESG risks will be completely introduced in banking management and there will be structured data, the supervisory assessment might cover all risks with the analysis of capital and liquidity.

The mechanism of the supervisory review is based on the consideration of the risk profile, but also the business model and the strategies adopted by the bank. Moreover, another check should be compliant with the IFD and IFR and with the financial risks afforded by the bank. The supervisory review is defined on the basis of the SREP

#### *Banking and Accounting Issues*

elements; and so there is the business model analysis, the evaluation of the internal governance, of the internal controls, the analysis of the risks to capital and to liquidity and funding.

ESG factors are ESG matters that may have different impacts on banks' financial performance because they can turn into ESG risks as financial risks as they are in the analysis of the supervisory process and in particular of the assessment of the viability and sustainability of banks' business model. For this reason, supervisors are interested in the forward-looking analyses implemented by the banks themselves, in non-financial reporting that contains a number of information useful to discover the level of attention to a sustainable economy and in the bank's ESG ratings. The supervisory process is changing in line with these new risks; banks are compelled to show their capacity and ability to afford and manage adequately their impact. New business models and a new and more effective supervisory function should be a forwardlooking assessment of the future business environment.

#### **3.2 Analysis of the business model and the ESG risk perspective**

In the previous paragraphs, the relevance of ESG factors and their possible characteristic of being a source of risks have been described. In addition, climate risk is considered one of the most important and actual risks in banks' regulation. These two assumptions are influencing also banks' business models.

Banks are organizing their activities to control their CO2 impact. At the same time, it is entering new selective methods in granting funds to green projects, avoiding the greenwashing trap that could increase ESG risks.

The business model is analyzed both under a quantitative dimension and from a qualitative point of view. The new business model being influenced by new risks requires also different capital adequacy. This adequacy is measured with respect to the capacity of absorbing ESG risks, while the qualitative analysis aims at the evaluation of the bank's performance considering its risk appetite, but also the presence of other drivers.

According to EBA and Basel Committee [3, 6], to understand the impact of ESG factors on the current business model, the quantitative analysis should be based on the consideration of the portion of the bank's profitability that derives from assets that are more exposed to ESG risks. The differences in the profitability of conventional loans and loans that include ESG risk-related objectives must be compared as the concentration of assets, highly exposed to ESG risks. The geographical concentration of lending or deposit-taking from households in a region where the economy heavily depends on carbon-intensive industries or that is prone to disasters is an example of the possible effects of ESG risks. The consequence is the search of assets and liabilities with more complex variables. For this reason, regulators are presenting new guidelines and banks are looking for new schemes for the development of more effective strategies.

#### **3.3 ESG risks and capital adequacy**

From the previous discussion, it is evident that ESG risks impact the existing financial risks (e.g., credit risk, market risk, and operational risk). If it is so, it is evident that regulators and supervisors need to consider the impact on capital requirement [11]. According to the function of capital requirement, its entity is tied

#### *Banking Regulation for ESG Principles and Climate Risk DOI: http://dx.doi.org/10.5772/intechopen.104110*

to the classification of risks to be faced. The risk-weighted assets are expressed on the basis of quantitative inputs classified by each bank starting from authorities' rules and regulations. The definition of capital requirement for ESG risks is influenced by their measurement and it is not yet well complied. In fact, as concerns climate-related risks and environmental risks a number of quantitative indicators are developing; on the contrary social and governance risks are mainly managed through qualitative methods. The supervisory position is focused on the way used to manage these risks, or better to analyze how banks are becoming aware of these risks. Right now the relationship under monitoring is the effects on credit risk profile.

As concerns ESG climate risk and environmental risks in determining capital adequacy is relevant the consideration that they are long term risk; in fact, the physical impact of environmental change and/or because previously insufficient political action forces a sudden and comprehensive transition.

Consequently, the supervisory process will be adapted to review whether and how the banks ensure that their banking book is sustainable in the medium to long term. To simulate the condition of risk, banks can adopt scenario analysis that gives a measure of the bank's resilience.

Supervisory activity tests capital adequacy by considering both qualitative and quantitative information. Anyway, the most important aspect is referred to the quantitative methodologies in which supervisory authorities assess bank's risk measurement tools. Starting from this approach to measure the relationship between credit risk and ESG risk, the standard credit risk assessment is used to take into account the impact of ESG risks. As credit risk is assessed in the short to medium term, the use of forwardlooking metrics is relevant to measure the impact of ESG factor on bank's own exposure to credit risk. This evaluation is important to measure the sustainability of long-term loans in the bank's banking book. In determining the capital requirement, the maturity of the loan portfolio is more and more important to absorb the impact of ESG risks. The starting point is connected to the evaluation of the awareness of how ESG risks drive credit risk for each portfolio and the connection with the risk appetite framework of the bank. For this reason, supervisors might check that institutions have properly embedded the material ESG factors into their rating assignment and review process.

The above-mentioned geographical variable is relevant also for determining capital adequacy; in fact, as said, the location has an influence on physical risk, so the higher is the risk of natural disaster, the higher should be the capital requirement to cover unexpected risks.

Even if there is the incorporation of ESG risks into the review of the credit quality of the portfolio, this causes a number of questions, one of which is the availability of reliable data and information. Supervisors will consequently check that the credit strategy is fully aligned and properly reflects the underlying ESG risk appetite. Performing these assessments also implies controlling how the responsibilities for implementing and monitoring the ESG-related targets are set.

The control of credit and loans implies the analysis of loans originating. At the end of this step, it means that it is necessary to identify projects, activities, and criteria used to select environmentally sustainable lending. This analysis is a guide to avoid greenwashing activities that might require a higher capital level, with a higher risk level [10]. This check on loan activity to quantify the capital requirement is necessary to cover the bank from the reputational risk, it might incur in.

While the link between ESG risks and liquidity and funding is seen by institutions as more indirect, it is deemed important to not overlook these links when evaluating

the risks to liquidity and funding; ESG factors could also result in funding issues for institutions or make some assets less liquid. The evaluation of liquidity needs in the short and medium term, in particular, whether ESG risks could cause net cash outflows that negatively impact the institution's liquidity position.

The analysis of ESG risks is still at an early stage, also because it is not yet simple in banking activity but it is relevant also for supervisory authority to assess the adequacy of internal capital to face these risks.

#### **4. Conclusion**

Environmental conditions and climate changes are influencing banking activity and regulators' duties. For a few years, ESG factors are impacting financial context and are inducing managers to adopt new approaches in running their business. Banks are changing their methods to consider the principles of sustainable finance both as concerns the banking book and consequently the loans activity, but also the new green investments. On the other side, climate changes and climate-related risks have demonstrated that the brown economy must leave the place to a green economy.

This new approach has induced banks to consider new risks deriving from the ESG factor and from climate change itself. Banking managers are reshaping their risk management scheme introducing also ESG and climate-related risks.

The framework is aggravated by the fast evolution of the social and governance models that must be structured in a new way.

Regulators and supervisors are running in giving guidelines and new frameworks to induce banks to pay more and more attention to these risks.

The whole supervisory process is reshaping by introducing the measurement of ESG risks and climate-related risks but the greatest problem is due to the huge relevance of these risks and the overlapping of rules, regulations, and guidelines that are still at an early stage but are renewing the banking activity whose main role to bring the economy to put in practice a real new green deal.

#### **Appendices and nomenclature**



### **A.Appendix 1 – ESG risks timeline implementation**

### **B.Appendix 2 – Climate regulation timeline implementation**



### **Author details**

Rosaria Cerrone Department of Management and Innovation Systems (DISA - MIS), University of Salerno, Fisciano, SA, Italy

\*Address all correspondence to: rocerro@unisa.it

© 2022 The Author(s). Licensee IntechOpen. This chapter is distributed under the terms of the Creative Commons Attribution License (http://creativecommons.org/licenses/by/3.0), which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.

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