However, possibly the most important point for corporates to be aware of is the planned move towards explicit use of the structured address block. In this second article in the ISO 20022 series, Zanders experts Eliane Eysackers and Mark Sutton provide some valuable insights around this industry requirement, the challenges that exists and an important update on this core topic. 

What is actually happening with the address information? 

One of the key drivers around the MT-MX migration are the significant benefits that can be achieved through the use of structured data. E.g., stronger compliance validation and support STP processing.  The SWIFT PMPG¹ (Payment Market Practice Group) had advised that a number of market infrastructures²  are planning  to mandate the full structured address with the SWIFT ISO migration. The SWIFT PMPG had also planned to make the full structured address mandatory for the interbank messages – so effectively all cross-border payments. The most important point to note is that the SWIFT PMPG had also advised of the plan to reject non-compliant cross border payment messages from November 2025 in line with the end of the MT-MX migration. So, if a cross border payment did not include a full structured address, the payment instruction would be rejected. 

What are the current challenges around supporting a full structured address? 

Whilst the benefits of structured data are broadly recognised and accepted within the industry, a one size approach does not always work, and detailed analysis conducted by the Zanders team revealed mandating a full structured address would create significant friction and may ultimately be unworkable. 

Diagram 1: Challenges around the implementation of the full structured address. 

From the detailed analysis performed by the Zanders team, we have identified multiple problems that are all interconnected, and need to be addressed if the industry is to achieve its stated objective of a full structured address. These challenges are summarized below:  

• Cost of change: The 2021 online TMI poll highlighted that 70% of respondents confirmed they currently merge the building name, building number, and street name in the same address line field. The key point to note is that the data is not currently separated within the ERP (Enterprise Resource Planning) system. Furthermore, 52% of these respondents highlighted a high impact to change this data, while 26% highlighted a medium impact. As part of Zanders’ continued research, we spoke to two major corporates to gain a better sense of their concerns. Both provided a high-level estimate of the development effort required for them to adapt to the new standard: ½ million euros. 
• Fit for Purpose: From the ISO 20022 expert group discussions, it was recognized that the current XML Version 9 message would need a significant re-design to support the level of complexity that exists around the address structure globally.  
• Vendor Support: Whilst we have not researched every ERP and TMS (Treasury Management System) system, if you compare the current structured address points including field length in the XML Version 9 message with the master data records currently available in the ERP and TMS systems, you will see gaps in terms of the fields that are supported and the actual field length. This means ERP and TMS software vendors will need to update the current address logic to fully align with the ISO standard for payments – but this software development cannot logically start until the ISO address block has been updated to avoid the need for multiple software upgrades.
• Industry Guidelines: Whilst industry level implementation guidelines are always a positive step, the current published SWIFT PMPG guidelines have primarily focused on the simpler mainstream address structures for which the current address structure is fine. By correctly including the more complex local country address options, it will quickly highlight the gaps that exist, which mean compliance by the November 2025 deadline looks unrealistic at this stage. 
• Regulatory Drivers: At this stage, there is still no evidence that any of the in-country payments regulators have actually requested a full structured address. However, we have seen some countries start to request minimum address information (but not structured due to the MT file format), such as Canada and US. 
• Time to Implement: We must consider the above dependencies that need to be addressed first before full compliance can logically be considered, which means a new message version would be required. Whilst industry discussions are ongoing, the next ISO maintenance release is November 2023, which will result in XML version 13 being published. If we factor in time for banks to adopt this new version (XML Version 13), time for software vendors to develop the new full structured address including field length and finally, for the corporates to then implement this latest software upgrade and test with their banking partners, the November 2025 timeline looks unrealistic at this point in time.

A very important update 

Following a series of focused discussions around the potential address block changes to the XML Version 9 message, including the feedback from the GLEIF³ the ISO payment expert group questioned the need to support a significant redesign of the address block to enable the full structured address to be mandated. The Wolfsberg Group⁴ also raised concerns about scale of the changes required within the interbank messaging space.

Given this feedback, the SWIFT PMPG completed a survey with the corporate community in April. The survey feedback highlighted a number of the above concerns, and a change request has now been raised with the SWIFT standards working group for discussion at the end of June. The expectation is that the mandatory structured address elements will now be limited to just the Town/City, Postcode, and country, with typical address line 1 complexity continuing to be supported in the unstructured address element. This means a blended address structure will be supported.    

Is Corporate Treasury Impacted by this structured address compliance requirement? 

There are a number of aspects that need to be considered in answering this question. But at a high level, if you are currently maintaining your address data in a structured format within the ERP/TMS and you are currently providing the core structured address elements to your banking partners, then the impact should be low. However, Zanders recommends each corporate complete a more detailed review of the current address logic as soon as possible, given the current anticipated November 2025 compliance deadline. 

In Summary 

The ISO 20022 XML financial messages offer significant benefits to the corporate treasury community in terms more structured and richer data combined with a more globally standardised design. The timing is now right to commence the initial analysis so a more informed decision can be made around the key questions. 

Notes: 

1. The PMPG (payment market practice group) is a SWIFT advisory group that reports into the Banking Services Committee (BSC) for all topics related to SWIFT. 

2. A Market Infrastructure is a system that provides services to the financial industry for trading, clearing and settlement, matching of financial transactions, and depository functions. For example, in-country real-time gross settlement (RTGS) operators (FED, ECB, BoE). 

3. Global Legal Entity Identifier Foundation (Established by the Financial Stability Board in June 2014, the GLEIF is tasked to support the implementation and use of the Legal Entity Identifier (LEI). 

4. https://www.wolfsberg-principles.com/sites/default/files/wb/pdfs/wolfsberg-standards/1.%20Wolfsberg-Payment-Transparency-Standards-October-2017.pdf 

Over the past decades, banks significantly increased their efforts to implement adequate frameworks for managing interest rate risk in the banking book (IRRBB). These efforts typically focus on defining an IRRBB strategy and a corresponding Risk Appetite Statement (RAS), translating this into policies and procedures, defining the how of the selected risk metrics, and designing the required (behavioral) models. Aspects like data quality, governance and risk reporting are (further) improved to facilitate effective management of IRRBB.

Main causes of volatility in SOT outcomes

The severely changed market circumstances evidence that, despite all efforts, the impact on the IRRBB framework could not be fully foreseen. The challenge of certain banks to comply with one of the key regulatory metrics defined in the context of IRRBB, the SOT on EVE, illustrates this. Indeed, even if regularities are assumed, there are still several key model choices that turn out to materialize in today’s interest rate environment:

• Interest rate dependency in behavioral models: Behavioral models, in particular when these include interest rate-dependent relationships, typically exhibit a large amount of convexity. In some cases, convexity can be (significantly) overstated due to particular modeling choices, in turn contributing to a violation of the EVE SOT criterium. Some (small and mid-sized) banks, for example, apply the so-called ‘scenario multipliers’ and/or ‘scalar multipliers’ defined within the BCBS-standardized framework for incorporating interest rate-dependent relationships in their behavioral models. These multipliers assume a linear relationship between the modeled variable (e.g., prepayment rate) and the scenario, whereas in practice this relationship is not always linear. In other cases, the calibration approach of certain behavioral models is based on interest rates that have been decreasing for 10 to 15 years, and therefore may not be capable to handle a scenario in which a severe upward shock is added to a significantly increased base case yield curve.
• Level and shape of the yield curve: Related to the previous point, some behavioral models are based on the steepness (defined as the difference between a ‘long tenor’ rate and a ‘short tenor’ rate) of the yield curve. As can be seen in Figure 1, the steepness changed significantly over the past two years, potentially leading to a high impact associated with the behavioral models that are based on it. Further, as illustrated in Figure 2, the yield curve has flattened over time and recently even turned into an inverse yield curve. When calculating the respective forward rates that define the steepness within a particular behavioral model, the downward trend of this variable that results due to the inverse yield curve potentially aggravates this effect.

Figure 1: Development of 3M EURIBOR rate and 10Y swap rate (vs. 3M EURIBOR) and the corresponding 'Steepness'

Figure 2: Development of the yield curve over the period December 2021 to March 2023.

• Hidden vulnerability to ‘down’ scenarios: Previously, the interest rates were relatively close to, or even below, the EBA floor that is imposed on the SOT. Consequently, the ‘at-risk’ figures corresponding to scenarios in which (part of) the yield curve is shocked downward, were relatively small. Now that interest rates have moved away from the EBA floor, hidden vulnerability to ‘down’ scenarios become visible and likely the dominating scenario for the SOT on EVE.
• Including ‘margin’ cashflows: Some banks determine their SOT on EVE including the margin cashflows (i.e., the spread added to the swap rate), while discounting at risk-free rates. While this approach is regulatory compliant, the inclusion of margin cashflows leads to higher (shocked) EVE values, and potentially leads to, or at least contributes to, a violation of the EVE threshold.

What can banks do?

Having identified the above issues, the question arises as to what measures banks should consider. Roughly speaking, two categories of actions can be distinguished. The first category encompasses actions that resolve an inadequate reflection of the actual risk. Examples of such actions include:

• Identify and re-solve unintended effects in behavioral models: As mentioned above, behavioral models are key to determine appropriate EVE SOT figures. Next to revisiting the calibration approach, which typically is based on historical data, banks should assess to what extent there are unintended effects present in their behavioral models that adversely impact convexity and lead to unrepresentative sensitivities and unreliably shocked EVE values.
• Adopt a pure IRR approach: An obvious candidate action for banks that still include margins in their cashflows used for the EVE SOT, is to adopt a pure interest rate risk view. In other words, align the cashflows with its discounting. This requires an adequate approach to remove the margin components from the interest cashflows.

The second category of actions addresses the actual, i.e., economic, risk position of bank. One could think of the following aspects that contribute to steering the EVE SOT within regulatory thresholds:

• Evaluate target mismatch: As we wrote in our article ‘What can banks do to address the challenges posed by rising interest rates’, a bank’s EVE is most likely negatively affected by the rise in rates. The impact is dependent on the duration of equity taken by the bank: the higher the equity duration, the larger the decline in EVE when rates rise (and hence a higher EVE risk). In light of the challenges described above, a bank should consider re-evaluating the target mismatch (i.e. the duration of equity).
• Consider swaptions as an additional hedge instrument: Convexity, in essence, cannot be hedged with plain vanilla swaps. Therefore, several banks have entered into ‘far out of the money’ swaptions to manage negative convexity in the SOT on EVE. From a business perspective, these swaptions result in additional, but accepted costs and P&L volatility. In case of an upward-sloping yield curve, the costs can be partly offset since the bank can increase its linear risk position (increase duration), without exceeding the EVE SOT threshold. This being said, swaptions can be considered a complex instrument that presents certain challenges. First, it requires valuation models – and expertise on these models – to be embedded within the organization. Second, setting up a heuristic that adequately matches the sensitivities of the swaptions to those of the commercial products (e.g., mortgages) is not a straightforward task.

How can Zanders support?

Zanders is thought leader in supporting banks with IRRBB-related topics. We enable banks to achieve both regulatory compliance and strategic risk goals, by offering support from strategy to implementation. This includes risk identification, formulating a risk strategy, setting up an IRRBB governance and framework, policy or risk appetite statements. Moreover, we have an extensive track record in IRRBB and behavioral models, hedging strategies, and calculating risk metrics, both from a model development as well as a model validation perspective.

Are you interested in IRRBB related topics? Contact Jaap Karelse, Erik Vijlbrief (Netherlands, Belgium and Nordic countries) or Martijn Wycisk (DACH region) for more information.

The Zanders purpose

Our purpose is to deliver financial performance when it counts, to propel organizations, economies, and the world forward.

With every improvement, fraudsters look for and find new opportunities to exploit. When the opportunity arises, some people see a big incentive or pressure to commit fraud, and most will be able to justify to themselves why it is acceptable to commit fraud (as shown in the Fraud triangle – Figure 1). Unfortunately, the impact of fraud on organizations, individuals and society in general is substantial.

More simply put, the EBA was asked to investigate whether the current prudential framework properly captures environmental and social risks. In response, the EBA published a Discussion Paper (DP) [1] in May 2022 to collect input from stakeholders such as academia and banking professionals.

These risks stem from the transition towards a low carbon economy and from the physical risks of damages due to extreme weather events. To address climate-related financial risks within the banking sector, the Basel Committee on Banking Supervision (BCBS) established a high-level Task Force on Climate-related Financial Risks in 2020. It contributes to the BCBS’s mandate to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability.

Both the BCBS’s Core principles for effective banking supervision¹ and the Supervisory Review and Evaluation Process (SREP) within the existing Basel Framework are considered sufficiently broad and flexible to accommodate additional supervisory responses to climate-related financial risks. It was felt, however, that supervisors and banks could benefit from the publication of the Principles for the effective management and supervision of climate-related financial risks². Through this publication, the BCBS seeks to promote a principles-based approach to improving risk management and supervisory practices regarding climate-related financial risks. The document contains principles directed to banks and principles directed to supervisory authorities. In this article, we present an overview of the principles directed to banks.

The BCBS published a draft of their Principles in November 2021. During the consultation phase, which lasted until February 2022, banks and supervisors could provide feedback. The BCBS incorporated their feedback in the final version of the Principles that were published in June 2022.

Principles for the management of climate-related financial risks

In total, twelve bank-focused principles are presented and grouped in eight categories. Each of the eight categories is briefly discussed below:

Corporate governance – Principles 1 to 3

The principles related to corporate governance state that banks first need to understand and assess the potential impact of climate risks on all fields they operate in. Subsequently, appropriate policies, procedures and controls need to be implemented to ensure effective management of the identified risks. Furthermore, roles and responsibilities need to be clearly defined and assigned throughout the bank. To successfully manage climate-related risks, banks should ensure an adequate understanding of climate-related financial risks and as well as adequate resources and skills at all relevant functions and business units within the bank. Finally, the board and senior management should ensure that all climate-related strategies are consistent with the bank’s stated goals and objectives.

Internal control framework – Principle 4

The fourth principle within the internal control framework subcategory requires banks to include clear definitions and assignment of climate-related responsibilities and reporting lines across all three lines of defense. Further requirements are then presented for each line of defense.

Capital and liquidity adequacy – Principle 5

After the identification and quantification of the climate-related financial risks, these risks need to be incorporated into banks’ Internal Capital (and Liquidity) Adequacy Assessment Process (ICLAAP). Banks should provide insights in which climate-related financial risks affect their capital and liquidity position. In addition, physical and transition risks relevant to a bank’s business model assessed as material over relevant time horizons, should be incorporated into their stress testing programs in order to evaluate the bank’s financial position under severe but plausible scenarios. Furthermore, the described incorporation in the ICLAAP to handle such financial risks, should be done iteratively and progressively, as the methodologies and data used to analyze these risks continue to mature over time.

Risk management process – Principle 6

The sixth principle connects to the previous one, as it states that a bank needs to identify, monitor and manage all climate-related financial risks that could materially impair their financial condition, including their capital resources and liquidity positions. The bank’s risk management framework should be comprehensive with respect to the (material) climate-related financial risks they are exposed to. Clear definitions and thresholds should be set for materiality. These need to be monitored closely and adjusted, if necessary, as climate-related risks are evolving.

Management monitoring and reporting – Principle 7

After ensuring that the risk framework is comprehensive, banks need to implement the monitoring and reporting of climate-related financial risks in a timely manner to facilitate effective decision-making. To achieve such reporting, a good data infrastructure should be in place at the bank. This allows it to identify, collect, cleanse, and centralize the data necessary to assess material climate-related financial risks. Furthermore, banks should actively collect additional data from clients and counterparties in order to develop a better understanding of their client’s transition strategies and risk profiles.

Management of credit, market, liquidity, operational risk – Principles 8 to 11

Banks should understand the impact of climate-related risk drivers on their credit risk profiles, market positions, liquidity risk profiles and operational risks. Clearly articulated credit policies and processes to identify, measure, evaluate, monitor, report and control or mitigate the impacts of material climate-related risk drivers on banks’ credit risk exposures should be in place. From a market risk perspective, banks should consider the potential losses in their portfolios due to climate-related risks. On the business operation and strategy side of banking activities, the impact of climate-related risks also plays a large role. For example, physical risks have to be taken into account when drafting business continuity plans. After understanding the different risks and their impacts, a range of risk mitigation options to control or mitigate climate-related financial risks need to be considered.

Scenario analysis – Principle 12

The final principle states that banks need to use scenario analysis to assess the resilience of their business models and strategies to a range of plausible climate-related pathways, and to determine the impact of climate-related risk drivers on their overall risk profile. Scenario analysis should reflect the overall relevant climate-related financial risks for banks, including both physical and transition risks. This analysis should be performed for different time horizons, both short- and long-term, and should be highly dynamic.

Changes to the BCBS risk framework draft and related publications

The final Principles have not changed much compared to the November 2021 consultation document. The most important changes are that the first principle, concerning corporate governance of banks, and the fifth principle, concerning capital and liquidity adequacy, have been extended. The corporate governance principle, for example, now also includes that banks should ensure that their internal strategies and risk appetite statements are consistent with any publicly communicated climate-related strategies and commitments. The capital and liquidity adequacy principle now includes a section requiring banks to incorporate material climate-related financial risks in their stress testing programs.

These twelve bank-focused principles, providing banks guidance on effective risk management of climate-related financial risks, can also be linked to the initiatives of other regulators such as the ECB. In November 2020, for example, the ECB provided a guide that describes how it expects institutions to consider climate-related and environmental risks, when formulating and implementing their business strategy, governance and risk management frameworks (the ECB expectations). These ECB expectations are in line with the BCBS Principles (and often more elaborate).

Zanders has gained relevant experience in implementing the ECB expectations at several Dutch banks. This experience ranges from risk identification and materiality assessments to the quantification of climate-related risks, ESG data frameworks, model validations, and scenario analysis. Please reach out to us if your bank is seeking support in implementing the BCBS Principles.

References
1) Basel Committee on Banking Supervision (2012). Core Principles for Effective Banking Supervision.
2) Basel Committee on Banking Supervision (2022). Principles for the effective management and supervision of climate-related financial risks.

In the below overview, we present an overview of the main ESG-related publications from the European Commission (EC), the European Central Bank (ECB), and the European Banking Authority (EBA).

This is complemented by the most important timelines that are stipulated in these regulations and guidelines. Additional regulations and guidelines that are expected for the next couple of years are also highlighted.

If you want to discuss any of them, don’t hesitate to reach out to our subject matter experts.

This topic is gaining momentum because of the European Commission’s Sustainable Finance Action Plan and associated regulatory changes.

One of the new requirements is that asset managers must incorporate sustainability risks in their risk management and reporting as of August 2022. This means that these risks must be measured, assessed and mitigated. However, this is not an easy task due to a lack of uniformity in risk management approaches and lagging data quality.

This prompted AF Advisors and Zanders to organize a round-table session on the subject. The large session turnout showed the importance of managing sustainability risks for the asset management sector. Parties that manage a total of no less than EUR 2.5 trillion in assets joined the session, including a broad selection of the largest asset managers active in the Netherlands. This attendance led to good, in-depth discussions. The discussion was preceded and inspired by a presentation from one of the expertized asset managers in the field of sustainability on how they mitigate, assess and monitor sustainability risks. Two hours of lively discussion is difficult to summarize but we would like to share a few interesting takeaways. Note that these takeaways do not necessarily represent the views of all the participants, though are merely an overview of the topics that were discussed.

Key takeaways

Financial risk management departments increasingly in the lead

While a few years ago, sustainability risks and the management of these risks were still the task of responsible investing teams in many organizations, this task is increasingly being taken up by financial risk managing departments as these are increasingly capable to quantify sustainability risks. This shift leads to new techniques and new requirements for data. Where previously exclusions were an important method for many parties, an integrated portfolio approach is emerging.

Lack of uniformity in the assessment of sustainability risks

The two main problems in managing sustainability risks are a lack of uniformity in approaches and a limited data quality or availability. Limited data quality is a well-known topic, especially for alternative asset classes. Specialized data vendors will be required to address these issues.

Important to realize, however, is that sustainability risk is such a broad and young concept that it is open to many interpretations. This means that the way in which sustainability risks are assessed can still differ considerably between parties. The benefit is that the different approaches help to speed up the evolvement of this new area. In the longer term it is expected that the assessments converge to a best market practice. Until then, there will be little standardization and different use of terminology. This is especially problematic in a multi-client environment with varying clients’ needs. Enforced communication by the regulator can therefore lead to outcomes that are hard to compare and interpret for clients. Listing definitions used and an explanation of the methodologies used is vital in communication on sustainability risks to clients.

ESG risk ratings are most popular concept despite drawbacks

The most frequently mentioned way in which sustainability risks are monitored is by means of environmental, social and governance (ESG) risk ratings. For example, by comparing a portfolio’s ESG scores with the scores of a corresponding benchmark and by limiting deviations. By using these ratings, environmental, social and governance factors are included. The major drawback of this approach is that it is partly backward-looking. Participants agreed, due to the long horizon over which most risks materialize, traditional (backward-looking) risk models may not be the most suited.

Most forward-looking data is available for climate risks. In addition to the use of ESG scores, a climate risk methodology is therefore desirable.

Not only European legislation matters

Next to European regulation, it is also important to consider emerging global initiatives and other regulation and reporting frameworks. US regulations such as US SDR can impact organizations and the approaches to sustainability risks to some extent. Global initiatives such as TCFD and TNFD are likely to influence and affect organizations’ risk management processes as well. Potential overlap must be analyzed so that an asset managers can face the challenges efficiently.

Internal organization

Sustainability risks can be defined and monitored at various levels of an organization. Portfolio managers should take them into account in the selection of investments. Second line monitoring and independent assessments must be in place. It is important to realize that this is not a topic that only affects the investment and risk management teams. The legislation explicitly places responsibility for managing sustainability risks on the board level and requires internal reporting, controls and sufficient internal knowledge of the topic.

Conclusion

Sustainability risk management is an important topic that asset managers will need to be working on in the coming years. It is expected that this field will evolve over time, it was even referred to as a ‘journey’. The deadline of MiFID, AIFMD and UCITS in August 2022 – date on which amendments of these regulations to incorporate sustainability risks come into effect – is an important first regulatory milestone but will certainly not be the last. With the organization of the round table, we hope to have assisted parties in getting a better understanding of the topic and to have contributed to their journey.

But to seize the opportunities ESG must become an integrated part of a bank’s strategy, risk management and disclosure regimes. High-quality data is instrumental to identify and measure ESG risks, but it can be lacking. FIs need to improve their internal data and use of external private and public vendors like Moody’s or the IMF, while developing a framework that plugs any data gaps.

The lack of appropriate ESG data is considered one of the main challenges for many FIs, but proxies, such as using a building’s energy rating to work out its carbon emissions, can be used.

FIs need climate change-related data that isn’t always available if you don’t know where to look. This article will give you an overview of the most relevant data vendors and provide suggestions on how to treat missing data gaps in order to get a comprehensive ESG framework for the green future where carbon measurement, assessment, reporting and trading will be vital

The data challenge

In May 2021, the Network for Greening the Financial System (NGFS) published a ‘Progress report on bridging data gaps’. In this report, the NGFS writes that meeting climate-related data needs is a challenge that can be described along the following three dimensions:

• data availability,
• reliability,
• & comparability.

A further breakdown of the challenges related to these dimensions can be found in Figure 1.

Figure 1: The dimensions of the climate-related data challenge.
Source: Graphic adapted by Zanders from a NGFS report entitled: ‘Progress report on bridging data gaps’ (2021).

Key financial metrics

The NGFS writes that a mix of policy interventions is necessary to ensure climate-related data is based on three building blocks:

1. Common and consistent global disclosure standards.
2. A minimally accepted global taxonomy.
3. Consistent metrics, labels, and methodological standards.

EU Taxonomy, CSRD & EBA’s 3 ESG risk disclosure standards

Several initiatives have started to ignite these needed policy interventions. For example, the EU Taxonomy, introduced by the European Commission (EC), is a classification system for environmentally sustainable activities. In addition, the recently approved Corporate Sustainability Reporting Directive (CSRD) provides ESG reporting rules for large listed and non-listed companies in the EU, including several FIs. The aim of the CSRD is to prevent greenwashing and to provide the basis for global sustainability reporting standards. Another example of a disclosure standard is the binding standards on Pillar 3 disclosures on ESG risks developed by the European Banking Authority (EBA).

Even though policy, law and regulation makers have a big part to play in the data challenge, there are also steps that individual institutions could and should take to improve their own ESG data gaps. Regulatory bodies such as the EBA and the European Central Bank (ECB) have shared their expectations and recommendations on the management of ESG data with FIs.

To illustrate, the EBA recommends FIs “[identify] the gaps they are facing in terms of data and methodologies and take remedial action” and the ECB expects institutions to “assess their data needs in order to inform their strategy-setting and risk management, to identify the gaps compared with current data and to devise a plan to overcome these gaps and tackle any insufficiencies”

Collecting data

Collecting ESG data is a challenging exercise. A distinction can be made between collecting data for large market cap companies, and small cap companies and retail clients. Although large cap companies tend to be more transparent, the data often is dispersed over multiple reports – for example, corporate sustainability reports, annual reports, emissions disclosures, company websites, and so on.

For small cap companies and retail clients, the data is more difficult to acquire. Data that is not publicly available could be gathered bilaterally from clients. For example, one European bank has developed an annual client questionnaire to collect data from its clients.

Gathering data from various reports or bilaterally from clients might not always be the best option, however, because it is time consuming or because the data is not available, reliable, or comparable. Two alternatives are:

1. Use tools to collect the data. For example, using open-source tooling from the Two Degrees Investing Initiative (2DII) to calculate Paris Agreement Capital Transition Assessment (PACTA) portfolio alignment.
2. Collect data from other external data sources, such as S&P Global.

This could be forward-looking external data on macro-economic expectations, international climate scenarios, financial market data or sectoral climate developments. Below we discuss some sources for external ESG and climate change-related data.

External data

Some of Zanders’ clients resort to vendor solutions for acquiring their ESG data. The most commonly observed solutions, in random order, are:

All the solutions above provide an aid to determine if climate related performance data is lacking, or can assist in reporting comparable and reliable data. They all apply a similar process of collecting the data and determining ESG scores, which is illustrated in Figure 2.

Figure 2: Data collection process for ESG data solutions (Source: Zanders).

Additionally, public and non-commercial data and solution providers are available, such as:

Missing data

Given the data challenges, it is nearly impossible to create a complete data set. Until that is possible, there are several (temporary) methods to deal with missing data:

• Find a comparable loan, asset, or company for which the required data is available.
• Distribute sector data based on market share of individual companies. For example, assign 10% of the estimated emission of sector X to company Y based on its market share of 10%.
• Find a proxy, comparable or second-best metric. For example, by taking the energy label as a proxy for CO2 emission related to properties, or by excluding scope 3 emissions and focusing on scope 1 and 2 emissions.
• Change the granularity level. For example, by gathering data on sector level rather than on individual positions.
• Fill in the gaps with statistical or machine learning techniques.

Conclusion

The increased attention to integrating ESG risks into existing risk frameworks has led to a need for FIs to collect and disclose meaningful data on ESG factors. However, there is still a lack of data availability, reliability, and comparability.

Several regulatory and political efforts are ongoing to tackle this data challenge, such as the EU taxonomy. More policy interventions, however, are required. Examples are additional mandatory disclosure requirements, an audit and validation framework for ESG data, and social and governance taxonomies that classify economic activities that contribute to social and governance goals.

In the meantime, FIs have to find ways to produce meaningful insights and comply with regulatory requirements related to ESG risks. Zanders has experienced that there is no one-size-fits-all solution for defining, selecting, implementing, and disclosing relevant data and metrics. It is dependent on the composition of the asset and loan portfolio, the use of the data, and the data that is (already) available. Regardless of how the lack of data is solved, it is important that FIs are transparent about their choices and methodologies, and that the related metrics and scorings are explainable and intuitive.

Sources:
https://www.ngfs.net/sites/default/files/medias/documents/progress_report_on_bridging_data_gaps.pdf
https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/eu-taxonomy-sustainable-activities_en
https://www.europarl.europa.eu/news/en/press-room/20220620IPR33413/new-social-and-environmental-reporting-rules-for-large-companies
https://zandersgroup.com/en/insights/blog/ebas-binding-standards-on-pillar-3-disclosures-on-esg-risks
https://www.eba.europa.eu/sites/default/documents/files/document_library/Publications/Reports/2021/1015656/EBA%20Report%20on%20ESG%20risks%20management%20and%20supervision.pdf
https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.202011finalguideonclimate-relatedandenvironmentalrisks~58213f6564.en.pdf
https://2degrees-investing.org/resource/pacta/

In total 104 banks participated in the stress test that was intended as a learning exercise, for the ECB and the participating banks alike. In this article we provide a brief overview of the main results.

The ECB’s goal with the climate risk stress test was to assess the progress banks have made in developing climate risk stress-testing frameworks and the corresponding projections, as well as understanding the exposures of banks with respect to both transition and physical climate change risks. The stress test therefore consisted of three modules: 1) a qualitative questionnaire to assess the bank’s climate risk stress testing capabilities, 2) two climate risk metrics showing the sensitivity of the banks’ income to transition risk and their exposure to carbon emission-intensive industries, and 3) constrained bottom-up stress test projections for four scenarios specified by the ECB¹. The third module only had to be completed by 41 directly supervised banks to limit the burden for some of the smaller banks included in the climate risk stress test.

An understatement of the true risk

The constrained bottom-up stress test projections show that the combined market and credit risk losses for the 41 banks in the sample amount to approximately EUR 70 billion in the short-term disorderly transition scenario. The ECB emphasizes that this probably is an understatement of the true risk, because it does not consider the scenarios underlying the stress test to be ‘adverse’. Second round economic effects from climate risk changes have, for example, not been factored in. Furthermore, only a third of the total exposures of the 41 banks were in scope and, on top of that, the ECB considers the banks’ modeling capabilities to be ‘rudimentary’ in this stage: they report that around 60% of the banks do not yet have a well-integrated climate risk stress testing framework in place, and they expect that it will take several years before banks achieve this. Even though banks are not meeting the ECB’s expectations yet, the ECB does conclude that banks have made considerable progress with respect to their climate stress testing capabilities.

Be aware of clients’ transition plans

A further analysis of the results shows that the share of interest income related to the 22 most carbon-intensive industries amounts to more than 60% of the total non-financial corporate interest income (on average for the banks in the sample). Interestingly, this is higher than the share of these sectors (around 54%) in the EU economy in terms of gross added value. The ECB argues that banks should be very much aware of the transition plans of their clients to manage potential future transition risks in their portfolio. The exposure to physical risks is much more varied across the sample of banks. It primarily depends on the geographical location of their lending portfolios’ assets.

The ECB points out that only a few banks account for climate risk in their credit risk models. In many cases, the credit risk parameters are fairly insensitive to the climate change scenarios used in the stress test. They also report that only one in five banks factor climate risk into their loan origination processes. A final point of attention is data availability. In many cases, proxies instead of actual counterparty data have been used to measure (for example) greenhouse gas emissions, especially for Scope 3. Consequently, the ECB is also promoting a higher level of customer engagement to improve in this area.

Many deficiencies, data gaps and inconsistencies

The outcome of the climate risk stress test will not have direct implications for a bank’s capital requirements, but it will be considered from a qualitative point of view as part of the Supervisory Review and Evaluation Process (SREP). This will be complemented by the results from the ongoing thematic review that is focused on the way banks consider climate-related and environmental risks into their risk management frameworks. The combination will indicate to the ECB how well a bank is meeting the expectations laid down in the ‘Guide on climate-related and environmental risks’ that was published by the ECB in November 2020.

The ECB notes that the exercise revealed many deficiencies, data gaps and inconsistencies across institutions and expects banks to make substantial further progress in the coming years. Furthermore, the ECB concludes that banks need to increase customer engagement to obtain relevant company-level information on greenhouse gas emissions, as well as to invest further in the methodological assumptions that are used to arrive at proxies.

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Notes
1) See our earlier article on the ECB’s climate stress test methodology for more details.