In many cases, the measures taken by small and medium-sized German banks to deal with climate-related and environmental risks remain somewhat modest. This was the result of an assessment performed by BaFin and the Deutsche Bundesbank as part of a thematic review of multiple institutions initiated by the European Central Bank (ECB). The review included 17 small and medium-sized institutions under direct supervision by BaFin (see info box).

With regard to the individual modules (see info box), there is room for improvement in particular in the areas of “Governance and risk appetite”, “Risk management framework” and “Credit risk”.

Five institutions received a red flag score for each of those modules. Moreover, the majority of reviewed institutions lack concrete key performance and key risk indicators for the effective strategic management and limitation of climate-related and environmental risks. Emerging practices could only be observed in a couple of cases. In general, such emerging practices involve the use of more granular data (e.g. at the level of individual borrowers) and quantitative methods in addition to purely qualitative approaches.

Nevertheless, this result means that German institutions performed slightly better than LSIs from other participating member states. The early publication of BaFin's Guidance Notice on Dealing with Sustainability Risks (see info box) likely contributed to this.

Altogether, there is considerable variation in the results for the German LSIs. One reason for this is the different business models and sizes of participating institutions. Another influencing factor for the overall result could be the support provided by the respective banking associations.

The results in detail

One question addressed to the institutions was whether they take climate-related and environmental risks into account when assessing the materiality of different risk types. All participating German LSIs have implemented basic practices in this regard. This means that they have a fundamental understanding of the impact of climate and environmental risks on their main risk types and that they take this impact into account in their materiality assessment of those risk types at least in a descriptive manner.

The vast majority of German LSIs could – based on the average of individual scores – also demonstrate at least basic practices in the module “Business environment and strategy”. There is room for improvement in particular with regard to the formulation of specific key performance indicators (KPIs), which institutions could use to effectively steer their strategic objectives on climate and environmental risks (see Figure 2). BaFin and the Bundesbank have also observed gaps in the coverage of all portfolios and relevant risk drivers.

Figure 2: KPIs of German LSIs

© BaFin / Own analysis

On average, across all individual elements of the “Governance and risk appetite” module, two thirds of the German LSIs under review had at least basic practices in place. As with KPIs, the assessment revealed potential for further improvement in the formulation of concrete key risk indicators (KRIs) and, consequently, in the way in which climate and environmental risks are taken into account with regard to the institutions' risk appetite (see Figure 3).

Figure 3: Risk appetite and key risk indicators of German LSIs

© BaFin / Own analysis

In many cases, German LSIs have already established basic practices in their risk management frameworks and have taken the first steps towards covering the different physical and transition risk drivers in their portfolios. However, there was a relatively high number of shortcomings with regard to the quantification of climate-related risks. This is in spite of the fact that simple methods – such as the breakdown of an institution's exposures according to the sensitivity of their clients' respective economic sectors to climate transition risks – would have sufficed for the institution's practices to be classified as basic. On a positive note, the supervisors from BaFin and the Deutsche Bundesbank were able to identify emerging practices in the area of risk mitigation methods at as many as five institutions.

The picture is similar for the “Credit risk” module. Considering the average score for all individual results within this module, around two thirds of institutions already have basic practices in place. However, the individual elements of the assessment show greater variation (see Figure 4):

Figure 4: Credit risk module

Due to one exceptional case, only 16 German LSIs were included in the “Credit risk” module © BaFin / Own analysis

Binding requirements to be introduced through planned amendments to the MaRisk

The results for German LSIs have not affected this year’s supervisory review and evaluation process (SREP). This is because the supervisory expectations set out in BaFin’s Guidance Notice on Dealing with Sustainability Risks were meant to provide guidance without being legally binding. This will change in the coming year: ESG risks will be included in the upcoming amendments to BaFin's Minimum Requirements on Risk Management (MaRisk). As in the Guidance Notice, the principles of proportionality, materiality and the freedom to choose which methods are applied have always been part of the MaRisk, and this is also the case for the requirements on dealing with ESG risks.

Specifically, the MaRisk will require institutions to explicitly deal with the impact of ESG risks on the risk types they have identified as material. Institutions will also be required to consider ESG risks at the strategic level, in the normative and economic perspectives of the internal capital adequacy assessment process (ICAAP), in their risk management and controlling processes, in stress tests, loan origination and internal risk reporting.

Given the current lack of reliable data in many cases, institutions may use qualitative and approximate approaches for a transitional period. From a supervisory perspective, the key question in assessing institutions' implementation of the MaRisk will be whether the institution-specific approaches consider the impact of ESG risks in a way that is plausible and proportionate to the institution's own risk profile. However, the supervisory objective is for institutions to progressively close data gaps and develop methods for the quantitative measurement of the impact of ESG risks.

Good practices provide guidance

Until the publication of the amended MaRisk, institutions can use BaFin’s Guidance Notice and good practices as a guide. For this purpose, supervisors from BaFin and the Bundesbank have identified suitable approaches from the review of the 17 German LSIs. The following table provides some examples of approaches used by small and medium-sized institutions for dealing with ESG risks:

The ECB has published a report on good practices adopted by participating SIs, which may also provide further guidance. However, their implementation is often more ambitious than the approaches taken by LSIs.