EBA report on incorporating environmental, social and governance risks in the supervision of investment firms

Luxembourg

On 24 October 2022, the European Banking Authority (“EBA”) released a report on incorporating environmental, social and governance (“ESG”) risks in the supervision of investment firms (the “Report”).

The Report, which is addressed to competent authorities, supplements the EBA report on the management and supervision of ESG risks for credit institutions and investment firms, published in June 2021 (the “2021 Report”). The 2021 Report (i) provides common definitions of ESG risks, (ii) elaborates on the arrangements, processes, mechanisms and strategies to be implemented by credit institutions and investment firms to identify, assess and manage ESG risks and (iii) sets up recommendations on how ESG risks should be included in the supervisory review and evaluation of those institutions that are subject to Directive (EU) 2013/36 (the capital requirement directive, “CRD”).

The principles set out in the 2021 Report are extended to investment firms subject to Directive (EU) 2019/2034 (investment firms directive, “IFD”), and Regulation 2019/2033 (investment firms regulation, “IFR”) (the “Investment Firms”) while taking into account the specificities of Investment Firms., such as (i) their business model, size, internal organisation, (ii) the nature, scale, and complexity of their services and activities, and (iii) the materiality of their exposure to ESG risks. 

The Report considers a proportionate and progressive assessment over time by competent authorities of the integration of ESG factors and risks into the business model, the internal governance and the risk assessment of Investment Firms.

Regarding the business model analysis, competent authorities conduct both a long-term quantitative and quality analysis of the business environment of Investment Firms from an ESG perspective in order to identify business lines, portfolio and investment product that are sensitive to ESG factors.  Competent authorities also examine the strategy and financial plans of Investment Firms and their business model of viability and sustainability in, respectively, short and medium term.  while taking into consideration i.a. risk appetite, balance sheet and assets under management, key internal and external dependencies and attractiveness for clients of Investment Firms.

Regarding the assessment of internal governance and risk management, competent authorities consider how ESG factors and risks management are incorporated into the overall internal governance framework in particular through (i) a suitable and transparent organisation and operational structure, (ii) a sound internal governance framework including an internal control framework (that are compliance function, risk management and internal audit function) and (iii) effective policies and processes to identify, assess, manage and mitigate ESG factors and risks. More specifically, the verifications cover the ESG risk-related in the strategy, the decision-making, the firm’s organisation structure and risk profile put in place by the management body in its management function, as well as its skills, expertise and knowledge in this respect. Moreover, ESG factors and risks may have an impact on the remuneration policies, on the internal control framework, on the effective and reliable information and communication technology of Investment Firms, and on their risk management framework.

Regarding the assessment of risks, ESG risks that may materialise at the level of Investment Firms’ capital or liquidity depending on its services and activities should be progressively and proportionally integrated into the prudential assessment of own funds in order to eventually consider increasing them.  In practice, the assessment covers (i) the risk-to-client (for example risks arising from Investment Firm’s assets under management, client money held, assets safeguarded and administered), (ii) the risk-to-firm (such as risk of losses from adverse movements largely depending on the ESG-sensitive nature of the instruments in which Investment Firms take positions, or counterparty failure from a number of Investment Firms’ ancillary activities such as granting loans to allow a client to carry out a transaction), (iii) risk-to-market arising from exposures on the trading book of an Investment Firm dealing on own account , and (iv) liquidity risk due to the sensitivity of liquid assets to ESG factors and risks.  Furthermore, ESG risks can create conduct, regulatory, legal, tax and reputational risk that should be assessed as the case may be and mitigated. 

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