 Climate change is upon us and the consensus is growing that we need to deal with it not tomorrow, not in 20 years, but today. Greening our economy requires banks to be stable because they're crucial to that transition, but they're exposed to climate risks too. That's why we looked at how banks are taking both climate and environmental risks so things like biodiversity loss into account in their business. We ask some questions like, do you have people responsible for climate risks in your organisation or is your business ready for the transition to net zero? Today we'll talk about the answers we got and whether what is written on paper actually happens in practice. You're listening to the ECB podcast bringing you insights into the world of economics and central banking. My name is Katie Ranger. To take us through what we found in this review, I'm very happy to welcome Executive Board Member and Supervisory Board Vice Chair Frank Eldersen back to the podcast. Frank, great to see you again. Thank you, Katie. Wonderful to be here. Now before we kick off, I just want to give our listeners a couple of facts about this assessment that we've carried out. We've been somewhat of a pioneer as supervisors in pushing the climate agenda and this exercise was no exception. Together with the national supervisors, we looked at 186 banks with combined assets of 25 trillion euros and that made it the largest supervisory exercise ever carried out on climate and environmental risks globally. Now the assessment which we know in the jargon as a thematic review was all about seeing whether banks are managing these risks in the way that we as supervisors expect them to. They'd already done a self-assessment last year and that was all based on a catalogue of expectations that we outlined in 2020, but this year it was us doing the assessing. Now Frank, let's unpack the overall findings, take a bit of a high level view of them. How are banks doing? I mean, you spoke in a speech in June this year when you talked about the preliminary results of good and bad news. How do things look now? Well, let me start by summarizing. Banks have started walking the talk, but there is still quite some walking distance to cover. Not to say actually there's a long way to go. Before we as a supervisor are satisfied with what banks are saying and this is actually the most important part of course, what banks are actually putting in practice across the board of all their activities. So all in all, I think you can say the glass is no longer empty, but it is not even close to half full. So let's start with the good news. Banks have made considerable progress. They have come a long way. Over 85 percent of banks have now put basic practices in place for managing climate and environmental risks in most areas. They incorporate the impact of these risks in their strategy and they have set initial objectives like achieving net zero by 2050 or gradually phasing out coal from their businesses. So I would say the institutional architecture to deal with the risks that stem from the climate and environmental crisis is there now. OK, so institutional architecture. What exactly does this mean on the ground in banks? What is what is happening concretely? Well, this covers different aspects. And for the moment, still focusing on the good news, I'll get to the other part. I'll remind you, don't worry. So banks have maps out where they are exposed to climate and environmental risks via the loans that they give to their clients. They have allocated responsibilities within the organization to deal with these risks and they have developed initial strategies to mitigate the risks for at least part of their exposures. OK, so they've identified the risks, found people to deal with them and identified sort of an initial way to deal with them. Right. So so let's make this concrete with an example. Climate has made it, if you like, to the top level. Almost all banks have given their management body, so their word, responsibilities in this area. And many consider climate expertise a must when choosing their top managers. Another example is data. It's a big topic and we have covered this, actually, in one of our other conversations about the member, Katie. So so the issue being a lack of robust data. And we welcome that most banks are analyzing their data gaps, because first you need to understand what data is missing so that you can actually then decide on the actions that that you have to take to, you know, to get the ball rolling. And in terms of data, I mean, this is important for climate because it's quite a new area for banks. And then it's still very much an area where they need to work on ways to get the data. And in some cases, the data just isn't there yet, right? Exactly. But you cannot hide behind those data not being there. Absolutely. Now, summing up, we saw a number of good practices and it shows that banks can innovate to tackle the challenges that they face in this vitally important area and that they can meet our supervisory expectations. OK, so good news is that banks have significantly improved, I'd say, since last year. They're starting to treat these risks like the other risks that they face. Let's go to the bad news. What's the bad news, Frank? Well, so so there is this progress. But of course, if you start with doing nothing or hardly anything, then anything you start doing is already significant progress. But there are still many things that concern us as a supervisor. There is still a long way to go. So let me just mention, you know, some of the most prominent issues. The processes that have been established they need to be much sharper and more precise to to make sure that banks, you know, really plan with more rigor what they need to do. So they're not quite developed enough yet. No. So what we see is a lot of what I would call basic tools, very blunt tools. And this is a start and a good start, but it's not enough. It's clearly not enough. And even for for for those banks that have more elaborate, more sophisticated, more granular processes already now in place, which, of course, is a good thing, then we see that they do not implement them consistently across the board. So that's this idea that you mentioned that they're not walking the talk. So, you know, to go on, there are gaps in how comprehensively banks address climate and environmental risks. So also to make that more concrete, a bank may look, for example, at flood risks for for its mortgages. But then they may omit to look at droughts for its large agricultural portfolio or the impact of CO2 price for its large energy clients. So they look at some and and and that that we, of course, welcome. But the danger is that that one becomes complacent and forgets about all the other things that also need to be done. Firstly, all banks we identified blind spots in the identification of risks. And 60 percent of those were considered to be major gaps. 80 percent of banks see themselves exposed over the short, medium or longer term to at least one risk type. And this is a big increase compared to last year. But they underestimate just how big that impacts could be. OK, so there's still quite a bit of work to be done. Now, you've obviously highlighted all these things to the banks. What exactly do the findings themselves mean for them? What are what are they going to do with that information now? Our findings will have concrete consequences for for banks. As I've said before, this is the year where the rubber hits the road. You know, all the banks we looked at received in depth feedback, flagging shortcomings and a clear timetable to tackle them. And on average, more than 25 shortcomings per bank were identified. OK, and these are things that they then need to remedy. They really need to tackle them. Exactly. And for two banks, we went a step further even. Our assessments affects their capital requirements. That's how much capital they need to hold, basically. Exactly. This means that they will have to put more money aside as a safety net to counter their high risk exposures to climate and environmental risks. So overall, what we want is that the banks meet our expectations by the end of two thousand twenty four at the latest. And we will monitor the progress that the banks may towards meeting that objective. And more importantly, we will not just monitor progress, but we will enforce progress so that our end of two thousand twenty four deadline for full compliance by all banks with all our expectations is met. OK, you kind of preempted my next question, Frank. Which was what happens if they don't? I mean, you said that we'll enforce it, but a little bit more concretely. Right. Well, I preempted it maybe because I'm I want to be adamant about this. So we are ready to take all supervisory measures that we have our at our disposal to enforce alignment with our expectations. And we are already asking banks to take action with some of them having received twenty five deadlines to act on. So they have homework and in our annual supervisory review process, we have already tasked 30 banks to remediate shortcomings by issuing legally binding requirements. We expect banks to follow up on these requirements and continue to work on full compliance with our expectations. And where we continue to see shortcomings, we can apply further supervisory measures, including capital requirements. Now, we've looked at the high level findings. I want to drill down a bit and look at a couple of the specific areas that the review looked at it looked at three main areas, governance, strategy and what we call risk management. Let's zoom in on two of those strategy and risk management. I want to look at strategy first. Now, what do we mean by that? Well, it's about banks understanding how they can be affected by climate and environmental risks and making sure that they steer their business on a path that will be viable and profitable in the years to come, even in the face of these risks here in Europe. We have a very clear objective here. The EU has set a legally binding goal to be carbon neutral by 2050. So, Frank, in terms of strategy, how are banks doing there? Many institutions have taken steps to understand how climate related risks might impact their business model. And they set out initial ways to adjust their strategy. So, for example, by communicating how they want to achieve net zero greenhouse gas emissions by 2050 or earlier in their own operations and in their lending activities. OK, so set out initial ways. Could you give me an example of that so I can imagine exactly what they're doing? So there's a small group of banks that are using what are called transition plans to see whether the business that they are engaged in will still work further down the line. So the background is that science is clearly telling us that we need to make massive changes across the economy, not only in the sources of power that we use to fuel our economy and everyday lives, but also the transport we use, the way we produce essential industrial goods like steel and semen, what we eat and how we produce it and, you know, and so on. Everything basically. So so we need to rapidly deploy green technologies and face out carbon intensive ones in all these industries. And this is what underpins the European Union's flagship European Green Deal package. Now, banks also understand that the commitments of governments will have a massive impact on the economy. And as a consequence, the citizens and companies that are their customers. And that is why banks are developing these transition plans to make sure that their strategies and risk management practices remain fit for purpose in a world that is on a path towards Paris. So does it mean that they will stop doing business with certain clients? Well, what we see is that banks adjust their products and set policies to phase out specific activities. So they have indeed also started talking to their clients about how they can adjust their business in a way that is compatible with where the bank wants to be in the future in terms of reducing the climate and environmental risks in in its portfolio. OK, so they're talking to their clients. It's not just a sense of it's not just a case of dropping them. Shall we say? Exactly. And we have seen banks that that require clients to implement time bound action plans. So importantly, these banks have processes in place to respond to cases where engagement fails, such as an as ultimately abandoning client relationships. So first, what you typically see is client engagement trying to convince and this trying to convince can become stricter by setting time bound deadlines, but then ultimately that can lead to abandoning relationships with certain clients. And this shift is key for banks themselves. A business with clients who may no longer have a sustainable source of income as a result of the transition comes with financial and even reputational and legal risks. That's just undeniable. So it sounds like you did actually see quite a few promising things in this area of strategy. Well, it shows that progress can be achieved, but there are, of course, some issues in most banks approach. It is still early stages. For example, going back to to one of the examples I mentioned earlier, some banks commit to reaching net zero emissions by 2050, which, of course, is very good. But they rarely provide concrete intermediate targets, highlighting how they are going to actually achieve that. OK, so the detail is lacking. Exactly. You know, many times I say it's easy as a CEO of a big financial institution of a bank to promise something that will be delivered by, I don't know, three, four, five CEOs down the line. True. Yeah. So saying net zero by 2050, although a completely necessary condition is not a sufficient condition, you need to understand what you're going to do today and tomorrow in the next two years and the next five years. So these are these intermediate milestones that we need to see. And some targets are just simply not ambitious enough. And also banks often don't say what will happen if they miss these targets, which is an important fact. So their strategies do not yet make their business model resilient to these risks or address all risks comprehensively. So they're still exposed in nine out of 10 cases. We found that bank strategies do not respond to all the risks to which they are exposed now or are likely to be exposed to in the future. For example, they don't consider all the geographical regions in which they are present, which is so important because climate and environmental risk is very much about geography in some cases. It is. And there's also a lot more focus on risks related to the energy transition than on physical risks of the climate and environmental crises, which are also important for banks' business. So overall, at this stage, institutions institutions still take too much of a wait and see approach in their strategic response to climate related risks. OK. So in other words, banks are moving forward, but their strategies are still far from being future proof. Blunt question. What is actually holding them back from doing all of this? I mean, it is clear that this is something that will ultimately affect banks' businesses in a massive way. And it's not as if they can just adjust later because later will be too late. So why aren't they acting now? OK. Let me let me start with the positive. What we are seeing is that banks have made considerable progress in helping the economy becoming greener. They are keen on new sustainable business and many actually have concrete plans to steering more of their funds towards sustainable business in the near future. But bank strategies are typically set for a three to five year long horizon. Climate and environmental risks tend to have a much longer horizon. Than other risks. In other words, these risks build up over time. OK. So the timelines don't quite line up there. Exactly. So careful planning and immediate short term action are needed. So it's not only a matter of looking further into the future than banks would normally do. It is also a matter designing a measurable pathway with concrete goals showing a bank what it needs to do today to maintain a resilient business model further down the road. So really about mapping the journey out in a detailed way. Exactly. And that's why it's so important that banks remedy the shortcomings that we have found and meet our expectations by the end of 2024 at the very latest. The transition plans I mentioned earlier. They are a very useful tool for that. They can help banks see where they might face risks because their business model is not aligned with the EU's, by the way, legally binding objective of being carbon neutral by 2050. All right, let's turn to the other area that I wanted to focus on risk management. Now, this is all about banks understanding how they can be negatively affected by climate change and the transition to a net zero economy and them working to mitigate the risks from that and ensuring that they are able to cover potential losses. Frank, this is a hugely important area for banks. Their core business is all about lending money to all kinds of clients. And that includes those in very carbon intensive sectors that are massively exposed to climate risks. Are banks taking this into account enough in their risk management processes? OK, I'm here again. My answer is going to be yes and no. So let me start with the positive. Almost all banks use at least basic ways to measure climate related risks and use solutions like proxies and assumptions when they do not yet have the data themselves. Many banks, I would say, have started to think about climate related risk when working out what we call their capital adequacy. So the right amount of capital that they need to hold to cover the risks linked to their assets. They need to do more work here, though, on quantifying these risks. At the moment, they often just describe them. They don't quantify them. And we also see progress in due diligence. Most banks are collecting information when choosing new clients. Now, on the more negative side, most banks have not yet developed methods that provide really detailed and forward looking data to understand how big the risks are. For example, farmland in certain regions might be more impacted by a rising number of drought and heat events than in other areas. And even within the same region, some farmers may have successfully adapted to climate stress through methods such as smart irrigation or more robust crop types. So the risk differs across the region. And while it's great that banks are taking those steps that may help identify where the risks lie, using proxies and assumptions doesn't provide that full picture that they need. Banks are struggling here. And this is why we have just published a list of good practices to help them learn from each other. OK, so they're practices that you've seen in banks that you've looked at. And the idea is to share them with all the banks so that they can learn what each other are doing. Exactly. You know, as a supervisor, we have this privilege that we can look, if you like, in the kitchen of each of these different banks. And of course, they cannot because they are competitors. But I think it is also fair to say that by having compiled these good practices, we hope that we can help banks to make that journey so that they can leverage on good practices that we have seen. And of course, we published those on a no-name space. But we have seen across the banking sector. OK, so there's still work to be done as well in the area of risk management. But there are some promising signs that banks are able to do that. Now, I just want to go back to something that was part of my last question. And that's this fact that banks still fund businesses that are not helping us move towards a more sustainable economy. Coal mines, for example. And banks do often come under fire for this. So shouldn't they just stop funding carbon intensive activities? You know, Katie, I'm glad you asked this question because it comes up all the time. And it's a fair question. For me, the answer is the following. Governments will have to decide when the last coal mine needs to close. That's up to them. That's up to those who are democratically elected. Banks will have to decide how they manage their climate related risks. And of course, there are transition risks related to any CO2 emitting sector. And that is, of course, very much the case with coal. Us as a supervisor have to make sure that banks manage their climate related risks, actually all their risks, but also their climate related risks and therefore also their transition risks in an adequate manner. So there will be a bank that will grant the last loan to the last coal mine in Europe. What is not OK if that bank does not have a clear plan what it will be doing the next day. So coming to that point, they need clear transition plans, how their whole balance sheet and if then the last loan will be that last loan, that is OK, as long as they have planned how they face this out. And they should ask the same thing from their clients. Their clients should also have these transition plans because in the end, the entire economy will become pairs aligned. And that means that banks to be able to manage their climate related risks will need to become pairs aligned as well and the sooner, the better. OK, so it's all about looking to the future, basically for them. Looking at the future, knowing that governments are implementing in a legally binding way, a pairs compatible path way towards net zero and making sure that as a bank moving in that same journey, you manage all your climate related risks in an adequate manner. And that is our role to to supervise that they do so. As part of that role, we're doing a few things to get banks management of climate and environmental risks to to where we want them to be, as you've just described. This review that we're talking about now was one of them. Another was the climate stress test that we spoke about on the podcast earlier this year, Frank, and we'll definitely link to that episode in the show notes for our listeners. Now, let's look a little bit to the future. What are the next steps for us as supervisors in this whole thing? OK, well, while backed by a central team of experts, this thematic review that we are talking about here today was done by the joint supervisory teams that are actually at the very hard of our day to day banking supervision. And with this, the supervision of climate and environmental risks have become fully embedded in our banking supervision. We are treating climate and environmental risks now in the same way as any other risks that bank banks face. And we will, of course, continue to do our part as supervisors. We will share best practices. We'll follow up with more assessments and we will take strict action when needed, which may impact capital requirements. OK, so these risks will really become a fundamental part of of what we look at as supervisors. What about for the banks themselves? Where should they go from here? Well, banks need to continue the progress that they have already made. And I would add not just continue, but they should accelerate. The current rate of change is not sufficient to reach the deadline that we have set for full compliance with all our expectations by the end of 2024 at the latest. Now, there is reason to be hopeful for each of our supervisory expectations. There is at least one bank and often many with good practices. The strategy, governance and risk management practices that some banks have started to adopt confirm that what we are asking for can be done by the banks. And maybe interesting also to add is that these are banks with different business models of different sizes in different geographies. So it's not just one or two niche banks that are good at this and the others can't. We see good practices across a wide range of different types of banks. And this gives gives hope that, you know, all banks can do this. Yeah, that's very promising. I mean, that it's not just the biggest banks or, as you said, the niche banks. Exactly. So it must be done and it can be done. Frank, thank you so much for breaking this topic down for us. Now, before we wrap up, we always have a question that we ask all our guests on the podcast. And that is for a hot tip link to the topic we are discussing today. Frank, do you have something for our listeners on the topic of climate and environmental risks? Right. Well, I thought about this a little bit and I have two things, but they are interrelated. Something to look out for this December is that leaders from around the world will meet in Montreal in Canada to define the future of the world's biodiversity. And and why am I mentioning this? You will have noticed, of course, that throughout this episode, throughout our conversation now, we have been talking all the time about climate and environmental risks and to protect the world that we live in and the biodiversity that we all rely on. We need new ways of protecting fresh water, marine ecosystems, new ways of reducing pesticides and plastic waste. And and again, we all need to do our part here. And so far, lots of all this is poorly defined and needs much more attention. And that is why I'm eagerly awaiting the outcome of the UN Biodiversity Conference in December, because in the end, all these things, as I said, also translate into risks for the financial sector. And that's why this is within the mandate of us central banks. This is I think I've seen this in the news. This is the COP 15, right? So we've got the COP 27 this year. And the COP 15 is the biodiversity part. Exactly. Exactly. So that is that is December. And then somebody hinted to me. So I looked at that and I thought it was very interesting to mention also to in the recent publication in a magazine of the Smithsonian Institute and and and they drew attention to Von Humboldt, the very at the time celebrated and well known scientist who made major contributions to science by showing maybe for the first time the interconnectedness of climate, geography, nature and human societies. And and I thought that was revolutionary at the time. But it is still very much relevant today. There is a wonderful book, of course, that he wrote and many books. But there is also a new show in the Smithsonian American Art Museum. So if you have time, at least to visit the website. OK, great. Two very interesting hot tips, as usual, Frank. Thank you very much. Thank you for having me, Katie. Well, that brings us to the end of this episode. I want to thank Frank Eldersen, executive board member and supervisory board vice chair for breaking down the results of our thematic review of climate and environmental risks on banks for us today. Check out the show notes for further reading on this topic. You've been listening to the ECB podcast with Katie Ranger. If you like what you've heard, please subscribe and leave us a review. Until next time, thanks for listening.