You have to know your risks to manage them – banks’ materiality assessments as a crucial precondition for managing climate and environmental risks

8 May 2024

By Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB

We have come a long way since we first started to discuss climate-related and environmental (C&E) risks with banks five years ago. Thanks to the banks’ own efforts and the ongoing dialogue between banks and supervisors, we have made good progress. I want to thank thousands of motivated C&E risk experts – bankers and supervisors alike – who through their hard work have built up notable expertise and achieved considerable progress. Across Europe, banks have taken decisive steps to integrate C&E risks into their strategies, governance and risk management. Most banks have now drawn up materiality assessments that are in line with the supervisory expectations we published in 2020. This is a fundamental step as materiality assessments are a crucial precondition for banks to be able to manage any kind of risk. But it is only the first step and a great deal more work lies ahead. 2024 is a crucial year for banks to make decisive progress in becoming more resilient to C&E risks.

A multi-year strategy to make banks more resilient to climate and environmental risks

Back in 2019, less than a quarter of the banks under our supervision had demonstrably reflected on how the climate and environmental crises were affecting their risk management. This observation was obviously concerning, so in 2020 the ECB published a guide on C&E risks setting out clear supervisory expectations about how banks should integrate these risks into their risk management, strategy and governance. In doing so, we were moving in lockstep with a broad global consensus in the Central Banks and Supervisors Network for Greening the Financial System (NGFS)^[1] and the Basel Committee on Banking Supervision^[2], acknowledging that C&E risks are a material source of financial risk and therefore need to be addressed by prudential supervisors.

Considering the clear requirements set out in the Capital Requirements Directive and the need for banks to identify and manage all their material risks, ECB Banking Supervision has repeatedly urged banks to ensure that they are managing C&E risks prudently. In other words, failing to adequately manage C&E risks is no longer compatible with sound risk management, just like turning a blind eye to other relevant risk drivers would not be acceptable either.

Over the past years, we have carried out a number of supervisory exercises to assess banks’ progress towards meeting our supervisory expectations. When we asked banks to do self-assessments in 2021, they reported that 90% of their practices were only partially or not at all in line with the ECB’s supervisory expectations. And this was despite half of the banks having already acknowledged the materiality of C&E risks. In 2022 we conducted a thematic review on C&E risks and a climate stress test, which again confirmed that banks considered themselves to be materially exposed to C&E risks.

Building on what the banks themselves found reasonable in their self-assessments and considering that most banks were still a long way from where they needed to be, we set a series of (interim) deadlines. First, we required banks to draw up adequate materiality assessments by the end of March 2023. Second, banks needed to integrate C&E risks into their governance, strategy and risk management by the end of 2023. And a last one at the end of 2024 by which banks should address these risks in full alignment with all our expectations. We have been clear that these deadlines apply to all banks and that - if and when necessary - we will use all the tools at our disposal to enforce these deadlines by when banks should have adequately addressed C&E risks.

Materiality assessments as a precondition for sound risk management

In our multi-year supervisory strategy, we have first asked all banks to ensure that they have sound and comprehensive materiality assessments in place. This means that banks must make an explicit judgement on the impact of C&E risks on prudential risk categories through various transmission channels across their portfolios and geographies in the short, medium and the long term. This is important because climate and nature risk events are not just one of the many standalone risks that banks face. They are instead a driver for each traditional type of risk reflected in the Basel framework, from credit risk, reputational and operational risk including legal risk, to market and liquidity risk.

Our preliminary analyses show that at the end of 2023 around 90% of the banks under our supervision considered C&E risks to be material, which is a significant increase compared with previous years. And when we look more closely at the various prudential risk types, we see an increase in materiality within each of the prudential risk categories, for both physical and transition risk and for the short, medium and the long term.

The outcome of the materiality assessment informs the follow-up actions in the risk management framework, for example through banks’ internal capital adequacy assessment processes. In other words, a materiality assessment is not just a “nice to have” – knowing your risks is a precondition for being able to address them.

Most, but not all, of the banks under our supervision made significant strides to advance their materiality assessment by the March 2023 deadline. We took action on this, in line with what we had communicated previously: we moved further up the supervisory escalation ladder^[3] and issued binding supervisory decisions for 23 supervised entities, which envisage the potential imposition of periodic penalty payments for 18 banks should they fail to comply with the requirements within the deadlines set out in these decisions.^[4] In other words, we told those banks to remedy the relevant shortcomings by a given deadline, and if they don’t comply, they have to pay a penalty for every day that the shortcomings remain unresolved.

Good practices are on the rise, but a number of bad practices remain

Overall, we see that banks’ materiality assessments are becoming more robust. Most banks now submit a meaningful overview of material C&E risk exposures for each risk category and across different time horizons to their management bodies, enabling them to take informed decisions on follow-up actions. We have seen examples of banks that have started to set aside capital to cover these risks and have enhanced their risk management processes to reflect the heightened materiality.

At the same time, we still see examples of banks’ materiality assessments that do not consider all relevant risk categories, that focus only on transition risks while largely omitting physical risks or that look only at a subset of geographical areas.

In addition, we still see banks adopting a net approach as opposed to a gross approach in the risk identification, which undermines banks’ ability to measure actual impact and articulate commensurate risk mitigation. This means that already when analysing the existence of risks, banks factor in risk mitigating actions. Instead, banks should assess the effectiveness of these mitigating actions after a correct risk identification.

Moreover, since C&E risks are inherently forward-looking using solely backward-looking historical data will inevitably lead to an underestimation of risks. Some frontrunner banks already make extensive use of forward-looking information to identify the C&E risk drivers for all portfolios and regions.

Material financial risks are not only limited to climate change but also concern broader nature-related risks that can no longer be ignored.^[5] Encouragingly, some banks have taken concrete steps to quantify the materiality of their exposures to nature-related risks. For instance, one bank ran several scenarios to simulate losses from physical and transition risk for instance stemming from continuing biodiversity loss and increased water scarcity. As our supervisory expectations explicitly cover also environmental risks, turning a blind eye to the materiality of those risks is clearly no longer compatible with sound risk management.

The path ahead

2024 is a crucial year for our supervisory priority to ensure that banks identify, measure and manage C&E risks.^[6] By the end of this year, we expect all banks under our supervision to be fully aligned with all our supervisory expectations on the sound management of C&E risks. And for this, the materiality assessment is just the first step. There is still a lot to do. For instance, by the end of the year we expect banks with material C&E risks to reflect them in the baseline and adverse scenarios of their stress-testing framework.

Although banks are still in the process of fully aligning themselves with all our expectations, every one of them has already been fulfilled by at least one bank. This shows that what we are asking banks is doable. To help banks advance their C&E risk management we have published the good practices we observed in both the climate stress test and the thematic review and we intend to update the reports going forward.

We will closely monitor banks’ progress towards meeting the supervisory deadlines. And, if necessary, as we did with the first interim deadline, we will use all the measures in our toolkit to ensure the sound management of C&E risks. These include imposing periodic penalty payments but also setting Pillar 2 capital requirements as part of the annual Supervisory Review and Evaluation Process if necessary to cover not properly managed risks.

To conclude, ECB Banking Supervision will continue to play its part in spurring on banks to identify, measure and – most importantly – manage material risks. What was considered material back in 2021 and 2022 is likely to be even more so in 2024, as the far-reaching consequences of the climate and nature degradation crises are more apparent than ever.

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