Integration of Climate Change Risk within RAF and ESG Assessment in Credit Risk Models
1 Environmental risk analysis in Banca Intesa Sanpaolo: recent developments
Background
The Paris Agreement on Climate Change, together with the UN 2030 Agenda for Sustainable Development, have laid the foundations for a more sustainable future. Sustainability and transition to a low-carbon economy, which are more efficient in terms of resources and circularity, are key elements of a specific action plan for ensuring the long-term competitiveness of the European Union.
Governments, firms and financial institutions are facing the catastrophic and unpredictable consequences of climate change and resource depletion. In particular, the financial system has already undergone several reforms during the past years to integrate the lessons learnt from the recent financial crisis, but it is ready to contribute to a greener and more sustainable economy. In this context, the European Union is committed to promoting more sustainable economic growth, to ensure the stability of the financial system and to promote greater transparency with a long-term view of the economy. In January 2018, the High-Level Expert Group (HLEG) on Sustainable Finance appointed by the European Commission in 2016 published a final report with a series of recommendations on key priority actions to develop an EU sustainable financial strategy. Some of the priorities highlighted by the HLEG have been
1 This chapter is written by Fiorella Salvucci, Head of Credit Risk - Corporate, Sovereign and Financial Institutions portfolio at Intesa Sanpaolo, email: fiorella.salvucci@intesasanpaolo.com; Fabio Garzaniti, Head of Internal Model Development Unit - Corporate, Sovereign and Financial Institutions portfolios at Intesa Sanpaolo, email: fabio.garzaniti@intesasanpaolo.com;
Andrey Karpov, Credit Risk Model Developer – Credit Risk Department at Intesa Sanpaolo; Fabio Verachi, Enterprise Risk Manager – Enterprise Risk Department at Intesa Sanpaolo.
Integration of Climate Change Risk within RAF and ESG Assessment in Credit Risk Models
included in the 2018 European Commission’s Action Plan for Financing Sustainable Growth, which was launched in March 2018.
With reference to financial markets, the European Commission aims at improving financial stability by integrating environmental, social and governance (ESG) factors into the investment decision-making process. The environmental aspects, such as the mitigation of climate change and adaptation solutions in response to global warming are specially taken into consideration by the EU. In fact, the inclusion of ESG factors in the decision-making process of public and private institutions play a fundamental role in European Commission’s Action Plan.2 The EU Action Plan for Financing Sustainable Growth aims at:
1. Redirecting capital flows towards sustainable investments, to achieve sustainable and inclusive growth;
2. Managing financial risks deriving from climate change, resource depletion, environmental degradation and social issues;
3. Promoting transparency and long-term vision in economic and financial activities.
ESG factors and governance improvements in the banking sector
The contribution of the banking sector to sustainable economic growth will depend on the ability of banking institutions to adapt their business models to the new needs emerging from environmental transformations. Banca Intesa Sanpaolo, in order to assess its ability to compete on the market and to develop in balanced conditions its economic-financial assets, is trying to integrate the results of the financial statements with an articulated and complex series of qualitative information, such as the products and services offered, the markets of reference, the sector structure, the degree of competition, the trend in demand, the technology used, the corporate governance and the quality of management.
The Board of Directors (BoD) and top management of Banca Intesa Sanpaolo take responsibility for promoting the risk culture and its inclusion in the strategy. Middle management is required to supervise the development of an adequate risk culture and create mechanisms for implementing the risk appetite. Following these principles, Intesa Sanpaolo is developing internal skills and a framework that would allow for the recognition of the ESG risks, thus adopting the recommendations of the Task Force on Climate-related Financial Disclosure (TCFD) as well as other provisions on sustainable finance (ESG, SDGs, EU Action Plan, etc.). The new competitive scenario, where the Bank operates, is generating a twofold effect:
• On the one hand, regulation is becoming more intrusive (e.g., through the possible introduction of a capital requirement for the risks associated with climate and other environmental factors);
• On the other hand, for some time now, the regulator has started to directly monitor the quality (viability and sustainability) of the banks’ business models (conduct, compliance, enterprise risk management models, corporate governance, etc.).
2 As an example, managers’ remuneration or the various incentives to protect stakeholder’s rights are tools aimed at guaranteeing the equality among the various interested parts of a company.
The TCFD and its main implications on the Group Risk Appetite Framework In June 2017, following the publication of the final report of the TCFD recommendations, some gaps emerged that had to be filled in the context of the management of ESG risks. Regarding climate risks, the analysis showed that the BoD should define and describe the governance and culture of ESG risks. Furthermore, the governance of financial intermediaries should define the roles and responsibilities regarding the purpose of its monitoring and evaluation.3
Intesa Sanpaolo is implementing this kind of guidelines. Indeed, the management responsibilities include the definition, approval and implementation of the overall business strategy and the related overall risk strategy. The Institution’s key policies, within the applicable legal and regulatory framework, include the risk appetite that must consider the benefits in the medium term and the solvency.4
The BoD maintains direct responsibility of this topic. The information related to climate change is provided to the BoD at least once a year and it is considered in defining the strategy, risk management, business objectives and investment policies. In light of this analysis, Intesa Sanpaolo has created a task force focused on corporate social responsibility (CSR) and the integration of ESG risks in the risk management framework, supporting the Risk Committee and the top management in its supervisory functions related to the monitoring of current and future overall risk strategy of the Bank.
The intensification of these discussions requires an improvement in the relationship with other internal risk processes, especially with the risk appetite framework (RAF), Internal Capital Adequacy Assessment Process (ICAAP), stress test and strategic planning. In fact, it is well known that risk and capital planning are an indispensable and integral component of strategic planning and the related documentary outputs merge with the business plan.5
Following the June 2017 TCFD recommendations, the key activities of the risk management department concern:
• Identification, assessment and measurement of climatic risks (transition risk and physical risk) of the Bank;
• Implementation, development and monitoring of a corporate-level risk governance framework, including risk culture, risk appetite and bank risk limits.
Moreover, the Chief Risk Officer Area, has the new task of identifying, assessing, measuring, monitoring and adequately managing all the risks related to climate risk (both transition and physical risk), guaranteeing that the identification and evaluation are not based solely on qualitative information but also take into account quantitative aspects and results of internal models.6
3 The climate risk for finance in Italy, Report of the Working Group 3 of the Italian Observatory on sustainable finance, 4 March 2019.
4 This approach is described in the report of the CoSo Framework: Enterprise Risk Management, Applying enterprise risk management to environmental, social and governance-related risks in CoSo, February 2018. In addition, the functioning of the board in the management of ESG risks is also in line with the CONSOB Report "Non-Financial Information as a driver of transformation", published on 25 March 2018.
5 See M. Baravelli, Sapienza University of Rome, M. Di Antonio, University of Genoa - The new regulatory model: how strategic planning changes in banks, Bancaria (2018).
6 In the credit risk internal rating model, with reference to climate risk, the Bank utilizes a qualitative questionnaire to assess the exposure of socio-environmental risks as well as environmental certifications are taken into consideration.
Integration of Climate Change Risk within RAF and ESG Assessment in Credit Risk Models
Within the Chief Risk Officer Area, the Enterprise Risk Management Head Office Department is becoming more and more involved in the ESG risk management process. These recent evolutions envisage that ESG risks should be identified, analyzed and managed in an integrated and cross-view way, involving all corporate functions, and that risk logics also become part of strategic decision-making processes. Although there is a regulatory pressure for improving internal governance to oversight these risks, the integration process is slightly slow compared to what is expected by regulators, because of the poor data quality and of difficulties in modeling the scenarios and adopt changes in the risk models.
In September 2019, the European Supervisory Authorities (European Banking Authority, EBA;
European Securities and Markets Authority, ESMA; European Insurance and Occupational Pensions Authority, EIOPA) stressed in a joint report on “Risks and vulnerabilities in the EU financial system” that financial intermediaries should incorporate ESG risks and, in particular, climate risks in the risk governance framework.
As a consequence, the Bank is even more committed to identifying, monitoring and incorporating these risks within its RAF. For instance, the calibration of the RAF metrics, the risk appetite, risk tolerance and risk capacity calibration activities are mainly addressed by the Enterprise Risk Management department which considers the analysis of the evolution of the business strategy, the prudential regulation and the stress scenarios, formulate the proposals to be submitted to the Board. In this context, particular attention is dedicated to methodologies and tools to model the Most Significant Transactions (MST): the priority is to evaluate ex ante the impact at least on the main RAF indicators of big tickets and to check, by using what if analysis, what risk position the Bank would put in place in case the transaction is actually implemented (compared to the RAF thresholds in force). Shortcomings in this sense can compromise the ability to critically evaluate the risk/return profile and understand the main profits drivers.
The RAF is approved by the BoD and reviewed, for possible modifications, at least once a year.
The Enterprise Risk Management function is strongly involved in its formulation as well as in the other already mentioned cross-functional processes (ICAAP and stress test). Furthermore, recent developments show that EU supervisors aim to review the Capital Requirements Regulation and Directive framework through a potential inclusion of ESG risks in the Supervisory Review Evaluation Process, including wider considerations on the second pillar such as risk management activities and stress tests.
Regulators are encouraging financial institutions to take ESG factors into consideration in their analyses. In fact, the speed at which these changes are taking place (just think of the European Commission activism in giving substance to its Action Plan for Sustainable Finance) could underestimate the fact that the financial sector cannot yet fully guarantee an effective and appropriate climate risk management. These difficulties derive above all from the already mentioned lack of hypotheses, models and scenarios capable of generating a large number of detailed information to be summarized in significant key performance indicators and/or key risk indicators.