European Commission’s review of EU banking rules sets the right objectives but is dangerously weak on climate change-related financial stability risks and implementation dates
BRUSSELS, 27 October 2021 – Finance Watch welcomes the objectives of the legislative proposals published today by the European Commission to review EU banking rules.
The package aims to finalise the implementation of the Basel III framework, embed ESG risks in prudential regulation and strengthen the supervision of the banking system. Unfortunately, if the objectives are the right ones the proposals are dangerously weak in two major aspects:
- Climate-related prudential risks are not adequately addressed;
- Delays in the implementation of key measures, in particular of the credit risk output floor, threaten to hurt competition and financial stability in the EU.
Thierry Philipponnat, Finance Watch’s Head of Research and Advocacy, said:
“By deciding not to tackle climate change-related systemic risks through Pillar 1 capital requirement measures, the Commission is failing on its duty to apply the precautionary principle enshrined in the Treaty on the Functioning of the European Union. Instead it relies on an illusory quantification of risks that will not only take more time than we can afford to spend given the urgency of the climate change situation, but also seems to ignore the conclusions of the recent reports produced by the NGFS and the ECB.
“The insistence of the European Commission on ‘regular climate stress testing by both supervisors and banks’ as a solution to tackle the link between climate change and financial instability sounds awkward at a time when the NGFS just stated that ‘methodological limitations may impair the usefulness of climate exercises to understand the need for targeted prudential policies to tackle climate risks, and to consequently calibrate possible prudential instruments’.
“In addition, the proposal gives itself the contradictory objective ‘to strengthen resilience, without resulting in significant increases in capital requirements’, in effect giving priority to banks’ return on equity ahead of citizens.”
Julia Symon, Senior Research and Advocacy Officer at Finance Watch, added:
“Coming just days before the COP26 in Glasgow, the Commission’s proposal is surprisingly weak on tackling climate-related financial risk. This is a missed opportunity for the EU to assume leadership and adjust prudential minimum capital requirements (Pillar 1) on fossil fuel exposures. Instead, the proposals contain only soft measures, which leave ample room for discretion to banks and will be neither effective nor timely.
“The current prudential rules do not take into account the risks that climate change poses to financial stability, which effectively equates to a fossil fuel subsidy and steers the economy into the next financial crisis, which will come on top of the climate crisis. This also undermines and counteracts the objectives of the whole EU sustainable finance agenda.”
Christian M. Stiefmueller, Senior Research and Advocacy Advisor at Finance Watch, commented:
“The international agreement on the finalisation of Basel III called for full implementation by 2028, a date that was already twenty years after the outbreak of the global financial crisis. The European Commission is now proposing to give EU banks an additional two-to-four years to implement some of the remaining measures, including the credit risk output floor which is important for financial stability and for ensuring a level playing field between small and large banks. With macroeconomic uncertainties increasing, these delays are not justified; they will hurt competition, transfer risk to citizens, and encourage other jurisdictions to lower their standards in response.
“Contrary to the banking sector’s representations, capital increases resulting from the completion of Basel III are not at all excessive and limited to a small number of institutions that have benefited disproportionately from the use of internal models. To reliably protect against future banking crises, capital levels would need to be strengthened even further and large institutions would have to become resolvable”.
Both sets of concerns are described in more detail below.
Climate change-related risks and financial stability
Climate change represents a major threat to financial stability, including the stability of the banking sector, and evidence suggests that the risk is growing with the time of inaction . Financing of fossil fuel exploration and production increases the systemic risk of climate change and leaves the banks with portfolios of assets that are likely to be partially or fully stranded, as governments proceed with transition policies towards a more sustainable economy. The major EU supervisor – ECB – has recognised that “current capital buffers do not capture climate-related financial risks owing to underlying risk weights that do not yet reflect climate-related risks to the full extent” . Yet, the Commission’s proposals clearly lack ambition in defining timely and impactful measures to ensure prudential rules for banks capture climate-related risks.
Instead, the Commission has opted for softer prudential measures to tackle climate-related risks, including the risks of misalignment with the EU’s policy objectives. The measures are focused on banks’ governance, strategy and risk management, as well as the supervisory review process (SREP) and stress testing. So-called climate stress testing, in particular, appears in the Commission’s proposal strikingly as an excuse to delay action at a time when the NGFS has concluded that “methodological limitations may also impair the usefulness of climate exercises to understand the need for targeted prudential policies to tackle climate risks, and to consequently calibrate possible prudential instruments” .
Overall, the proposed measures leave a high degree of methodological discretion to banks, which will lead to regulatory divergence in their application. Thus, these measures will not tackle the doom loop linking the banking system and climate change. Individual financial institutions cannot be expected to come up with consistent approaches to identify, measure and monitor climate-related risks at the time when supervisors themselves recognise the unique features of these risks and challenges of their quantification [2,4]. Different existing alignment methodologies are incomplete and incomparable, thus increasing the risk of greenwashing .
From a governance standpoint, the CRD proposal fails to include clear obligations for the banks to set sustainability targets and transition pathways as well as to align a proportion of the management body’s remuneration with those targets.
The two EBA mandates – (1) to explore by 2023 whether any prudential capital requirements should be put in place to reflect climate-related risks and (2) 18 months from date of entry into force of the amended CRD (effectively most probably not before 2025), to define minimum standards and reference methodologies for the ESG risk management, including misalignment with the EU policies – will effectively delay action and lead to much higher risks to the financial system and the economy overall .
Risky delays to stability measures
The Basel III reforms came in response to the global financial crisis of 2008/09, an economic disaster that plunged Europe into its most severe recession since World War II and nearly destroyed the common currency. The reforms were meant to address the root causes of that crisis: excessive risk taking by the banking sector and systemic risk emanating from a small number of global financial institutions deemed ‘too big to fail’.
One of the key enabling factors for excessive risk-taking in the banking sector has been the ability of the largest banks to fine-tune their internal risk models to optimise returns while minimising capital requirements. In addition to allowing these banks to operate with inadequate capital, this practice also puts smaller banks, which tend to apply the standardised approach (SA) to calculate capital requirements, at a distinct competitive disadvantage. The final instalment of Basel III contains a number of critical measures to address these well-documented issues, in particular an ‘output floor’ that aligns the risk weights of banks using internal models (IRB) with the standardised approach. Moreover, certain categories of exposures will no longer be eligible for the IRB approach at all.
The proposal suggests introducing the output floor from 2025, with a transition period extending to 2030. This is contrary to the Basel III agreement, which calls for the full adoption of the output floor by 2028. For specific categories of exposures, the proposal foresees even longer phase-in periods, until 2032. In a fast-changing world where global macroeconomic risks are building up at great speed this is simply not good enough.
Banking sector competition
Ever since the finalisation of Basel III in December 2019, the banking sector has held policymakers to their apparent promise that the completion of the framework should not result in further significant increases of regulatory capital requirements. No distinction was made between the notions of ‘increasing capital requirements’ and ‘increasing capital’. The finalisation of Basel III, notably the ‘output floor’, does not increase capital requirements – it merely ensures that the capital requirements that are in place are met evenly by all market participants. Where they result in material increases in regulatory capital is for the very largest banks, eight Global Systemically Important Institutions and a handful of Other Systemically Important Institutions. The remainder of the EU banking sector appears to have been swept along on a campaign to preserve the advantages of their larger competitors, by delaying a change that would help to level the playing field between large and small credit institutions.
Furthermore, several provisions in the Commission’s proposal appear to be aimed at placating banks rather than improving the supervision of them, for example by limiting the discretion of supervisors to impose Pillar 2 capital requirements (P2R) and systemic risk buffers (SyR).
Another area of concern is the implementation of the new framework for calculating capital requirements to cover operational risk, a category of risk that is becoming ever more important at a time when procedures in banking are automated at a relentless pace, data transferred to the ‘cloud’ and systems exposed to increasingly sophisticated cyberattacks.
The final Basel III framework requires banks to comply with a new Standardised Measurement Approach (SMA) for operational risk, which consists of an indicator that reflects the inherent risk profile of a particular line of business, the Business Indicator (BI) component, and a second component which accounts for past losses the bank incurred in this line of business over the last ten years, the Loss Component (LC). The latter is recommended by the Basel Committee for all larger banking units (with a BI exceeding EUR 1 bn) but does not figure in the Commission’s proposal.
According to the proposal, large EU banks should be required only to collect and report operational loss events but not to meet additional Pillar 1 capital requirements to account for shortcomings of their operational risk management that contributed to these losses in the first place.
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For more information, contact James Pieper, Finance Watch on +32 496 51 72 70 or at firstname.lastname@example.org
Notes to editors
The European Commission press release dated 27 October 2021 announcing the proposals is available here.
Finance Watch published on 27 October 2021 a letter from 110 organisations and 60 prominent academics and civil society figures from around the world calling on the EU and global leaders to impose more stringent capital requirements on banks and insurers that finance new fossil fuel projects.
Finance Watch has published two reports on prudential regulation of climate systemic risk in the banking and insurance sectors: Breaking the climate-finance doom loop and Insuring the uninsurable, as well as a Letter to EU policymakers.
 Supervisors confirmed that there are clear benefits for financial institutions of acting early on climate-related financial risks rather than delaying action. See, for example, S. Alogoskoufis, N. Dunz et al, ECB economy-wide climate stress test: Methodology and results, ECB Occasional Paper Series, No 281, September 2021.
 I. Baranović et al., The challenge of capturing climate risks in the banking regulatory framework: is there a need for a macroprudential response?, ECB Macroprudential Bulletin, 19 October 2021. The capital requirements proposals made by Finance Watch in its June 2020 report Breaking the climate-finance doom loop were recognised by an international panel of 50 banks, NGOs, academics, regulators and investors as the top-ranked policy proposal to tackle the link between climate change and financial instability. See Financial Stability in a Planetary Emergency, Climate Safe Lending Network, April 2021.
 NGFS, Scenarios in Action: A progress report on global supervisory and central bank climate scenario exercises, Technical document, October 2021.
 The major challenges with respect to measurement of climate risks were highlighted by the NGFS, BCBS and EBA in the following reports: NGFS, Progress report on bridging data gaps, May 2021; BIS, Climate-related financial risks – measurement methodologies; Climate-related risk drivers and their transmission channels, April 2021; EBA Report on management and supervision of ESG risks for credit institutions and investment firms, 23 June 2021, p. 62, 95-97.
 ShareAction, Paris-alignment methodologies for banks: reality or illusion?, April 2021; Portfolio Alignment Team (led by D.Blood, I.Levina), Measuring portfolio alignment: Assessing the position of companies and portfolios on the path to Net Zero, Q4 2020.
About Finance Watch
Finance Watch is an independently funded public interest association dedicated to making finance work for the good of society. Its mission is to strengthen the voice of society in the reform of financial regulation by conducting advocacy and presenting public interest arguments to lawmakers and the public. Finance Watch’s members include consumer groups, housing associations, trade unions, NGOs, financial experts, academics and other civil society groups that collectively represent a large number of European citizens. Finance Watch’s founding principles state that finance is essential for society in bringing capital to productive use in a transparent and sustainable manner, but that the legitimate pursuit of private interests by the financial industry should not be conducted to the detriment of society.
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