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.
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 super- visory 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 forward- looking 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 conven- tional loans and loans that include ESG risk-related objectives must be compared as the concentration of assets, highly exposed to ESG risks. The geographical concentra- tion 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
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 physi- cal 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 quanti- tative 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 forward- looking 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 embed- ded 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.