The Prudential Regulatory Authority’s (PRA) recent decision to press pause on Basel 3.1 rules reflects a dilemma confronting policymakers across major economies. Their attempts at resolution will have significant implications for the banking sector and beyond.
In January, the PRA said it would delay the UK’s implementation of the final revisions to the global capital and risk framework by 12 months to January 2027. It cited “competitiveness and growth considerations”, meaning uncertainty over the adoption plans of the new US administration.
In all developed markets, there is a renewed emphasis on the need to support economic growth and the competitiveness of strategically important economic sectors, while also recognising the continuing need for rules to protect consumers and minimise systemic risks.
This tension between short and long-term priorities can be seen in efforts to incorporate sustainability factors into financial decision-making, including via prudential risk and reporting rules. Climate risk is increasingly being highlighted by global regulators as a key driver of financial risk, but other environmental, social and governance (ESG) considerations are also receiving attention.
While policymakers and regulators believe banks should take greater account of these risks, they don’t want to hobble the flow of finance to economies that have struggled to grow since the pandemic. Banks themselves seem uncertain as to the right balance, with several global players taking the decision to quit global coalitions addressing climate change, while maintaining their own net zero commitments.
Banks must choose their individual paths, ensuring compliance, while also delivering on their own competitiveness and growth agenda, where ESG can play a critical supporting role.
Early mover
Let’s first look at the regulatory and then the competitive landscape to see how ESG factors are beginning to be integrated not only into risk and reporting rules, but also banks’ business models.
UK financial regulators were among the earliest to recognise the scale of climate change’s potential impact on financial returns. Published in 2019, the PRA’s first supervisory statement on enhancing banks’ and insurers’ approaches to managing the financial risks from climate change was updated last November, addressing gaps and inconsistencies in firms’ efforts so far, and reflecting developments in best practice and guidance in the interim.
It outlined enhanced expectations across governance, (underlining board-level responsibilities), risk management, scenario analysis, and disclosure, pointing out existing Pillar 3 disclosure obligations under capital adequacy regulations. The PRA encouraged banks to go beyond these in terms of transparency – particularly regarding how they integrate climate-related financial risks into governance and risk management processes – and insight into their “evolving understanding of the financial risks from climate change”.
In January, the PRA put regulated entities on notice in its annual letter to CEOs, highlighting the need for further progress, notably regarding climate scenario analysis and risk management.
UK banks should expect further uplift in climate-risk reporting regulations, as the Basel Committee is currently finalising its proposed Pillar 3 disclosure framework for climate-related financial risks, which will then be introduced by local regulators from 2026 onward.
Holistic integration
These ever-rising obligations are challenging enough for banks, but institutions also operating in Europe arguably face steeper – and certainly earlier – obligations.
To get a sense of what’s coming down the pike, UK banks should take a look at the European Banking Authority’s (EBA) approach to implementing Basel III, which has been more explicit and rigid in its requirements – and more far-reaching in its scope.
While the EBA’s roadmap to the completion of Basel III’s reforms runs broadly in parallel to that of the PRA, there are important differences when it comes to taking account of ESG risks. Critically, European banks are expected to achieve holistic integration of ESG risks into their governance, strategy and risk management frameworks, ensuring alignment with their individual business strategy and Europe’s climate goals – also taking full account of social and governance risks alongside climate and environmental ones.
Banks have had fair warning. The EBA has been rolling out and expanding the reach of its Pillar 3 ESG reporting requirements since 2023, when it introduced annual disclosures on transition and physical risks arising from climate change for large institutions. Last month, the scope of Europe’s Pillar 3 ESG reporting requirements was extended to 2,000 banks, under a proportional approach yet to be fully defined by the regulator.
Under this, the EBA requires template-based disclosures on banks’ transition risks (including Scope 3 emissions and exposures to carbon-intensive firms, plus risk governance, scenario testing and stress testing); physical risks (quantitative and qualitive descriptions and mapping of exposures); and mitigating actions (covering strategies for reducing risk exposures, and support for clients’ transition to sustainable practices).
Banks must also disclose two metrics – the Green Asset Ratio (GAR) and the Banking Book Taxonomy Alignment Ratio (BBTAR) – which measure changes in the exposure of banks’ financial assets to climate change and other ESG risks.
Economic fundamentals
For all its embrace of the need for banks to report and manage ESG risks more effectively, Europe has sent out some mixed messages.
Just over a year ago, Frank Elderson, Vice-chair of the Supervisory Board of the European Central Bank, warned banks of penalties and the potential imposition of Pillar 2 capital requirements to ensure sound management of climate and nature risks, also insisting that “more work is needed” to improve the quality and consistency of disclosures.
And yet, earlier this month, a number of European central bankers told Bloomberg of the need to simplify the regulations facing European banks to ensure a level playing field globally. This call comes alongside a European Commission push to streamline many of its rules – starting with sustainable finance – as recommended in the recent Draghi report on competitiveness.
As with the accelerating adoption of clean energy technologies, economic fundamentals are beginning to play a greater role than government policy in driving the integration of ESG factors into financial decision-making. This is largely because access to accurate ESG information helps banks know their customers better, enabling them to identify and price risk more precisely. Evidence suggests using ESG metrics as an input into credit risk decisions reduces defaults and pricing, which in turn allows lenders to take on more and safer business, driving funding costs lower and returns higher.
A recent study by Bain & Co identified a statistically relevant correlation between higher ESG performance and lower credit risk among SME borrowers from Rabobank across geographies and industries. This low default rate of firms exhibiting strong performance has enabled the Dutch bank to offer more accurate loan pricing.
Similar dynamics in a separate study see banks that follow responsible banking practices – including taking account of ESG factors in lending decisions – have been able to source funds a higher ‘greenium’ than rival banks in the green bond market. Elsewhere, research suggests banks that integrate ESG issues into corporate strategy and capital allocation decisions are delivering higher risk adjusted returns.
Mounting evidence
Political appetite for introducing more rules – either in the banking sector or elsewhere – is far from strong, even as evidence mounts that they can help minimise material financial risks and allocate capital more efficiently.
In both the UK and Europe, timelines may continue to shift for climate risk reporting and further integration of sustainability factors into the governance, strategy and risk management processes of banks – and indeed corporates. On the one hand, this may give banks more time to adjust; on the other, it could delay access to valuable ESG inputs into their lending decisions.
Ultimately, policy uncertainty is the enemy of investment and growth, because it delays decisions across the economy. It may slow the pace of change, but the overall direction seems clear, with the Basel committee confirming last November that the final stages of Basel III implementation would include proposals on climate-related financial risks. If there are further delays, banks should grasp the opportunity it affords. The time for action is fast approaching.
Don’t wait for regulations to catch up. Contact The Disruption House today to start collecting the high-quality ESG data you need across your value chain, transforming regulatory challenges into competitive advantages.
