Reporting and Governance

The Covid-19 pandemic has done little to dull the appetite of EU regulators to drive climate change policies, as proven by the ECB’s guide on the matter. Given the scope of work needed to meet the ECB’s expectations, banks are advised to starting acting now. By David Strachan and Hina Majid at Deloitte's EMEA Centre for Regulatory Strategy

The European Central Bank’s (ECB) decision to launch a consultation on its draft Climate and Environmental Risk Guide in the midst of the Covid-19 pandemic signals a strong desire to set a brisk pace for eurozone banks to manage such risks, and for their management bodies to be held to account. 

In addition to responding to the ECB’s consultation, banks should focus on mobilising resources to perform gap analyses against the ECB’s draft expectations, while developing implementation roadmaps to address identified shortcomings. It is important for banks to act now for the following reasons.

First, the finalised guide is presently scheduled to apply to significant institutions (the largest banks, directly supervised by the ECB) by the end of this year, upon publication (the exact publication date is yet to be publicly confirmed). While the guide is subject to ongoing consultation until September 25, 2020, we believe the outcome is unlikely to result in significant amendments. 

Second, while banks might take comfort from the ‘non-binding’ nature of the guide, they already know that they will form the basis of supervisory dialogue with the ECB. Indeed, the ECB has indicated that as of next year it will enter into a supervisory dialogue with banks in order to discuss divergence from its expectations, while examining banks’ plans to address these gaps. And if banks’ experiences with Brexit are anything to go by, the ECB is likely to make its expectations stretch a long way.

Third, the ECB’s expectations are notable for their comprehensive and detailed nature. Indeed, the ECB’s guide sets out a total of 13 expectations covering: strategy and risk appetite, governance and accountabilities, climate risk data and reporting, regulatory disclosures and risk management including stress testing, scenario analysis and capital planning, with expectations for all of the principal risk categories (credit, market, liquidity and operational risk).  In short, the ECB’s aim is to ensure that banks integrate climate and environmental risk into everything they do.

Consistent with this, each of the 13 expectations is underpinned by a series of more granular details. For example, in relation to risk appetite, expectation 4.3 requires that remuneration policies and practices are consistent with climate and environmental risk approaches, as well as ‘voluntary commitments’ made by firms. In relation to risk management, expectation 7.6 details requirements to ‘regularly consider the appropriateness and quality of data sources and methods in place’ in the light of evolving methodologies. 

Expectation 6.2 addresses adapting IT systems to systematically collect and aggregate data to assess risk exposures. And under the organisational structural requirements, which require assignment of responsibility for climate and environmental risks, there are specific expectations for the first, second and third lines of defence. The comprehensive and detailed nature of these granular expectations will in turn make it more challenging and resource intensive to conduct gap analyses, and plan to address shortcomings.

Expectations on novel risks

This challenge is compounded by the fact that the guide and its expectations also extend to environmental risks, including those flowing from, for example, biodiversity loss, air, water and land pollution, water stress and deforestation. While De Nederlandsche Bank and Netherlands Environmental Assessment Agency have, for example, recently issued high-level ‘recommendations’ in their report relating to biodiversity risks, environmental risks are a relatively novel area where there is limited industry expertise and on which supervisors have said very little to date.

Fourth, the simplicity of the guide’s language is unlikely to be carried through into implementation. For example, expectation 7.4 states that ‘Institutions are expected to conduct a proper climate-related and environmental due diligence, both at the inception of a client relationship and on an ongoing basis.’ Expectation 8 requires that in firms’ credit risk management, ‘institutions are expected to consider climate-related and environmental risks at all stages of the credit-granting process and to monitor the risks in their portfolios’. The latter would envisage changes to the whole credit process along with the associated tools, techniques and data. 

Similarly, the guide requires that ‘As part of [banks’] capital planning, institutions are expected to assess their capital adequacy under a credible baseline scenario and institution-specific adverse scenarios’.  As the ECB makes clear in its evaluation of banks’ practices, ‘Only a few institutions include climate-related risks in their stress testing and reverse stress-testing scenarios, and the practice of assessing the capital impact and capital requirements… remains limited.’

Meanwhile, expectation 3 asserts that the management body is expected to consider climate-related and environmental risks when developing the institution’s overall business strategy, business objectives and risk-management framework, and to exercise effective oversight of climate-related and environmental risks. This again is no small feat and will necessitate considerable planning and resourcing – both human and financial, as well as data (including key performance and risk indicators) – to support this.

The long and short of it is that when one contemplates the work, costs, planning and resourcing involved in addressing a baker’s dozen of expectations in a 45-page document in the available timeframe, the magnitude of the entire compliance task ahead should become clear. Taking the ECB’s implementation timetable at face value, banks need to start acting now.

A Speakers’ Corner is an area where open-air public speaking, debate and discussions are allowed. The original and most noted is in the north-east of Hyde Park in London

This article is free to read, request a no obligation trial access to Global Risk Regulator.