ESG Risks into the Risk Management Framework

ESG risk management is becoming an essential component of banks’ sustainability strategies. In line with the prudential approach to risk management, this chapter focuses on ESG risks that can thus be defined as the negative materialization of ESG factors through their counterparties or invested assets. ESG factors can have positive or negative impacts on banks through their core business activities. In the negative side, ESG factors may impact banks’ financial operational, liquidity, and funding risks, in addition to impacts attributable to the bank exposure to its counterparties and invested assets. ESG factors lead to negative financial impacts through a variety of risk drivers. The chapter presents the definitions of ESG risks separately and describes the ESG risk drivers, their transmission channels, and how these can impact on traditional bank risk categories. The chapter deepens the importance of integrating ESG risks in the risk identification, assessment, and monitoring process, in line with the provisions of the competent European Authorities. The integration of ESG risks in banking activities can be divided into two macro-phases: assessment and evaluation of exposure to ESG risks (which involves an “as is” analysis and the classification of exposures based on ESG variables) and then definition of the adjustment to the Risk Management Framework following the identification and the assessment of ESG risks. The effective strategies of banks should include ESG dimensions into bank risk frameworks considering that ESG risk is not a fully stand-alone risk type. Based on a holistic approach to banking risks within the risk management process, ESG risks influence financial and non-financial banking risks through complex cause–effect relationships across them.