Introduction

Sustainability is a topic everyone is talking about – and rightly so: the need to enshrine the notion of sustainability more profoundly in society is becoming increasingly obvious. That is seen already from a look at issues like pollution and climate change that are the focus of this article. In the past 20 years alone, meteorologists have observed 18 of the hottest years since weather records began¹ in the middle of the 19^th century.² For good reason, the European Union (EU) therefore committed itself in the Paris Agreement on Climate Change to reducing CO₂ emissions by 40 per cent by 2030 compared with 1990.³

But a serious ecological makeover of the economy will call for unprecedented efforts. The current debates on energy and traffic policy provide a foretaste of that. And you don’t have to be a prophet to argue that climate change will also entail massive changes for the European finance industry – and thus also the banking sector. If we sit back and do nothing at all or not enough, the impact will be all the more dramatic (see Table 1).

Table 1: Expected economic impacts for different warming paths

Source: Own table – based on Chief Risk Officers Forum, January 2019

But what might a banking sector that can be called sustainable in the true sense of the word look like – and what is the role of supervisory authorities in such context? The following are some considerations about how BaFin banking supervisors will steer their supervisory resources to a course for greater sustainability.

Sustainability risks and opportunities

For a long time, sustainability for banking supervisors was the responsibility of the capital markets since initially the focus was primarily on producing the resources for achieving climate targets. But banking supervisors and regulators also have to deal with the subject since climatic, environmental and socio-ethical changes will not spare the banking sector either – not to mention the considerable risks that might be associated with them even if their impact is not always felt immediately. This is something that was already made clear in the Progress Report published in October 2018 by the Network for Greening the Financial System (NGFS) that brings together various central banks and supervisory authorities. The comprehensive Report by the Network published on 17 April 2019 recommends supervisory authorities, among other things, to include climate-related risks in the supervision of financial institutions.

At the same time, sustainable financing holds opportunities for banks and savings institutions – both ecologically and economically. The financing requirement is huge: according to estimates, the energy sector and related infrastructure alone in the EU will need 175 to 290 billion euros⁴ each year to meet climate protection targets agreed on by the Member States of the United Nations Framework Convention on Climate Change on 12 December 2015 in Paris⁵.

It is up to the credit institutions to identify these opportunities and prepare for them in their business models and structures. In the long term, institutions failing to adapt might not be able to attract any more investors and customers as well as young, motivated employees. I dare say that in the long term only those credit institutions geared to sustainability will themselves have a sustainable existence on the market.

Description of sustainability risks

From climate and environmental risks to financial risks

Climate and environmental risks, social risks and risks arising from corporate governance are also described by the abbreviation ESG (environmental, social and governance)⁶. Currently, though, sustainability is primarily associated with climate and environmental risks.

Climate and environmental risks can be subdivided into:

• Physical risks: these include damage from storms, heavy rainfalls, floods, hail, extreme snowfall, drought, rising sea levels and the gradual worsening of production and working conditions. Banks – unlike insurance undertakings – are not primarily affected by direct physical risks but only in special situations, as when a centralised data centre is no longer operational due to an extreme weather event, which is something that should already be addressed by the operational risk.
• In the banking sector, indirect physical risks are the more serious risks. For example, customers may default on their loans because their bank-financed buildings or production facilities have been destroyed. Or because their income base has been diminished or destroyed – as in the case of crop failures in the agricultural sector, to give just one example. The indirect physical risk is enhanced if the collateral furnished for the financing can be physically destroyed or if buildings or production facilities are no longer insurable.
• Transitional risks: these include risks resulting from politically motivated changes, as when prices for fossil fuels are deliberately increased and environmental taxes are introduced. But even the risk of customers turning their backs on ”dirty” companies falls under this category – as do the effects of new and potentially disruptive technologies and liability risks to polluters⁷. In the financial sector, transitional risks are almost exclusively indirect. For credit institutions, they come into play particularly as a result of valuation risks, for example as a result of impairments on property or enterprise values.
• Financial stability risks: the effects of physical and transitional risks will be felt by markets more profoundly than can be imagined today. They might even give rise to financial stability risks.

All types of risks previously taken into account by banking supervisors – credit, market, operational and liquidity risks – also have a sustainability risk dimension (see Table 2). That means that from a supervisory viewpoint no need arises for a separate category “sustainability risk“.

Table 2 shows how the various environmental and climate-related risks are to be classified into the existing risk structure:

Table 2 Classification of sustainability risks into current risk structure

Source: BaFin

My British colleagues from the Prudential Regulation Authority (PRA) have examined their banking market. They found that 30 per cent of the surveyed institutions view climate risks primarily as a matter of corporate social responsibility (CSR). However, 60 per cent regard such risks as financial risks on a three-to-five year horizon and ten per cent even adopt a long-term strategy⁸. Even if the UK market differs in some points from the German market, financial climate-related risks also affect all risk types here as well.

Credit and counterparty default risks

In the case of credit and counterparty default risks, sustainability risks are reflected both in the borrower’s probability of default and in the value of the collateral. Example: A storm destroys a loan-financed office building. Even in developed markets, the collateral is insured only to less than ten per cent of the gross domestic product, excluding (term) life insurance policies.⁹ That means there is a high likelihood of losses arising which are uninsured and would have to be offset by equity capital. Pundits from the insurance industry hold a world that is four to five degrees warmer to be no longer insurable¹⁰, which may pose a threat to the existence of borrowers in the event of one-off or recurring disasters.

Many retail banks see an increased risk of flooding and the risk of devastating storms as the most significant climate-related financial risks. But even the transformation of energy policies and structural climate changes may cause losses and interruptions in business.

Market risk

In the case of market risk, the physical risks have a direct impact through prices. A destroyed crop is no longer available to the market, regardless of whether the cause was heavy rainfall or a period of drought. But if extreme weather events increase and climatic conditions worsen, this may have a negative impact on macroeconomic variables such as economic growth, employment levels and the rate of inflation, for example if public infrastructure suffers and tax revenues fall¹¹ . But that is not all: if the rating agencies start increasing the risk ratings of countries, regions and local government entities as a result of climate events and if their bonds are downgraded as a result, a vicious circle could ensue. Credit rating agencies are therefore increasingly developing methods to rate the physical impacts of climate change on countries.

The ecological transformation of the economy will also have a noticeable effect on the nature and scope of economic growth as well as on the productivity and make-up of investments. Coming on top of that is the inevitable burden of carbon-intense industries that will also result in changes in the prices to be paid for the various forms of energy and commodities. For example, in 2018 changes in the EU emissions trading scheme resulted in a record price for the certificates of 25 euros per tonne of CO₂, a jump of 300 per cent over twelve months. But according to scientific studies, 100 euros per tonne of CO₂ or more would be needed to actually meet the two-degree target of the Paris Agreement – and that not only in the EU.¹² An abrupt and far-reaching revaluation of the climate-related financial risks could destabilise the markets and lead to a procyclical trend. A simultaneous response of credit institutions to this might turn critical especially if it is not clear which banks have such risk positions on their books. High losses and liquidity problems would then be imminent.¹³ In the worst case, a tense risk situation might even be exacerbated by third-round effects.

Operational risks

The situation is somewhat different for operational risks (OpRisk). There is no question that climate change increases the OpRisk risk profile. Extreme weather events can adversely affect business continuity and even have an impact on branches and group-internal service providers in other parts of the globe. Generally, the direct physical risks for credit institutions are covered by the operational risk. But this does not ring true for all reputational risks that might arise because banks have missed the window of opportunity to re-orient themselves to sustainability, if for example their business practices are deemed immoral and legal risks arise. The market mood is changing. Increasingly, stakeholders are closely watching how the banking sector responds to climate change.¹⁴ That is why credit institutions have to scrutinise their business relationships to emissions-intense companies with a view to their strategic orientation.

Regulatory and supervisory treatment of sustainability risks

It is only when we grasp sustainability-related risks that we can also manage them correctly at the regulatory and supervisory level. What we need are policies and approaches that actually work in practice. A suitable regulatory framework is provided by the Basel framework with its three pillars. Pillar 1 covers minimum capital requirements, Pillar 2 the basic principles of qualitative banking supervision and risk management in banks, and Pillar 3 the disclosure requirements.

Pillar 3 approach

First of all, we take a look at the transparency requirements of Pillar 3, since it is here that we find the tools we need to establish real comparability between financial products and to reduce greenwashing. Moreover, one of the primary objectives must be to enable investors to make the deliberate choice for green, less green or even brown investments. Of course, I am not under any illusions about the fact that private investments in green assets in some cases are also the expression of personal convictions that may change. What remains from that is something we will learn when the economy slows and personal financial activities are perhaps once again defined only by expectations for returns.

On the other hand, sustainable financing has long ceased to be a matter for a small, particularly ecologically oriented clientele. Brown investments carry the risk of generating a loss in value in the medium to long term.

The objective of transparency must also be the ability to assess the long-term nature of investments. A sustainable investment is a long-term investment. And we all have to show those who even today still think in terms of one quarterly report to the next that long-term investments are also worthwhile. The work on a uniform taxonomy in Europe has not yet been completed.

Transparency as an advertising tool

Greater transparency is something that benefits not only investors but also companies. The latter do well to see new transparency requirements not as a burden or rampant bureaucracy but as an opportunity to proactively use their commitment to greater transparency as a means to vie for customers. They can do this, for example, by openly communicating the criteria for their financing and investment activities as well as the values motivating their management. Credit institutions that succeed in conveying their sustainability approach will gain crucial momentum for their own financial future. To a certain extent, they are already required to do this by the Regulation on disclosures relating to sustainable investments in the financial sector¹⁵. Young customers are taking a keen interest in these issues and to a decisive extent take account of ecological and social aspects in their economic decisions. As the current “Fridays for Future” protests by school students show, a sustainable future is hugely important for the young generation. These young demonstrators of today are the bank customers of tomorrow.

Pillar 2 approach

We now take a look at Pillar 2 of the Basel framework and thus at the integration of aspects of sustainability into the Supervisory Review and Evaluation Process (SREP). In the fifth European Capital Requirements Directive (CRD V), the European Banking Authority (EBA) has been given such review mandate for the integration of sustainability aspects. But before discussing the allocation of capital for Pillar 2 risks, we should first of all draw up the “soft” requirements. Until the EBA mandate is completed, the focus will initially be on bank control, risk management and governance. Institutions should take a top-down approach – from the management board to the departments – to the new risks or those risks perceived to be new, develop a strategy and a fitness check. What are the main drivers of an institution’s own business? Where can the effects of sustainability risks be felt? Which portfolios are concerned? Which processes might have to be adjusted? Are new risk limits to be set? Is the organisational structure still right? All these points are already abstractly addressed in the German Banking Act (Kreditwesengesetz – KWG) and the Minimum Requirements for Risk Management (MaRisk). BaFin will therefore formulate its ideas for the specific integration of sustainability risks initially as expectations based on recommendations and then engage in public consultations. By the end of 2019, BaFin will publish a paper in which it states how it envisages the integration of sustainability aspects into the risk management of the credit institutions.

These expectations will then be validated with financial industry representatives. Of course, banks and savings institutions already having suitable processes in place will be able to demonstrate to the supervisory authority that they already sufficiently take account of the newly drafted expectations. With its paper, BaFin particularly wants to address those institutions that are only now just beginning to grapple with the issue of sustainability. We want to draw their attention to the changing risk situation and make them aware that they have to reflect on their strategic orientation, their organisational and operational structure, and on how they communicate both internally and externally. We also wish to provide banks and savings institutions with a guideline on which to orient themselves when it comes to defining the necessary level of transparency. We will later review the management of sustainability risks also in the context of our ongoing supervision and thus gradually achieve a solid Pillar 2 coverage, possibly with additional capital requirements.

Pillar 1

From the outset, the Pillar 1 capital requirements were the subject of very controversial debate in international forums dealing with the coverage of sustainability risks in financial markets. Particularly the green supporting factor that some have called for gave rise to heated discussions – in the financial industry and with supervisory authorities alike. Should once again a social or political objective be shifted onto the bank’s balance sheets? As much as I understand this intention, I also have to urge caution as a supervisor. So far, there have been few models for a green supporting factor. Many questions still have to be clarified to ensure adequate risk coverage of “green“ and “brown“ risk positions.

In the context of the second European Capital Requirements Regulation (CRR 2), the EBA is given a corresponding review mandate and will submit a report to the European legislative bodies within six years. What is needed is reliable data. But it will be possible only with difficulty to estimate how investments in sustainable assets will develop in crisis based on current data alone¹⁶. If sustainability risks are to be forecast realistically, it will be indispensable to establish additional expertise.

Conclusion

In conclusion I would like to emphasise that sustainability for me is much more than just a subject I am dealing with in a professional capacity. Sustainability for me is something personal and close to my heart. Anyone taking an honest, realistic look at the world around us cannot but recognise just what challenges are facing society – and thus also the banking industry – as a result of climate change. We will succeed in adequately meeting these challenges only with a committed and strategically well positioned financial industry – and not without or even against it. For the banks and savings institutions, that means a great deal of tedious and difficult adjustments, but also opportunities. Ecological and social arguments will make it possible to attract new customers and motivated employees. Those who negligently miss the opportunities of sustainability will take on risks society might no longer be willing to assume.

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