Climate change and the transition to a climate-neutral economy are presenting banks with major challenges. Whilst extreme weather events such as the flooding in Germany’s Ahr Valley in 2021 have a direct impact on banks’ loan collateral, the consequences of the general rise in temperature have a much more multifaceted and complex effect on banking risks. 

These also include policy measures to limit climate change, which may affect banks’ corporate customers, in particular, via factors such as higher costs for greenhouse gas emissions. That said, climate action measures are only part of the catalogue of measures drawn up by the European Union (EU) to achieve the United Nations’ sustainable development goals. In addition to climate objectives, it also includes other environmental objectives, social objectives and the promotion of good corporate governance. The acronym “ESG” (environmental, social, governance) is used to summarise these sustainability categories. Banking supervisors must manage these ESG risks adequately. 

ESG risks and their relevance to banking supervision

The risks to banks stemming from ESG measures, or even from delays in taking these measures, are those that are relevant to risk-based banking supervision. However, ESG risks are not entirely new types of risk for banking supervisors. Instead, they can be understood as drivers of known risk categories, such as credit or market risk, that conventional methods struggle to fully capture and quantify. 

This is because regulatory requirements and established risk analysis methods are largely based on historical data. However, these are only of very limited use in predicting how ESG risks could manifest in the future and translate into financial risks. Moreover, the specific transmission channels that result from a rise in the average temperature are difficult to capture and quantify. Banks therefore need to develop new approaches. Supervisors such as the Federal Financial Supervisory Authority (BaFin) and standard-setters have published guidance on this at the national, European and international level in the form of guides on supervisory practice and banks’ risk management. These are intended to raise banks’ awareness of climate and ESG risks and help them implement supervisory expectations.

Banks do not yet meet expectations

However, various studies show that most banks have fallen short of the supervisory expectations of the ECB and BaFin so far. Supervisors will therefore focus on the progress made by banks in implementing the existing requirements over the next few years. For example, the ECB has made climate risk a strategic priority for its supervisory activities in the period 2022-2024. BaFin and the Bundesbank have also defined ESG risks as medium-term issue to focus on in the period up to 2025. In supervisory practice, the intention is to regularly address ESG risks in supervisory discussions and to intensify dialogue with the associations. Findings from ESG reporting and the Bundesbank’s climate risk stress test will support the ongoing work.