ESG rating as input for a sustainability capital buffer

Abstract

In this paper, we give a state of the art overview of what ESG ratings are, which different types of these ratings can be distinguished and how they could be used in banking regulation to adjust banks’ capital requirements with the goal to promote green finance and reduce climate-related risks within the investments of banks. Based on experience collected with other supporting factors within banking regulation, like the SME supporting factor, we show how a Green Supporting Factor or a Brown Penalty Factor could be implemented to promote green finance or punish brown finance, respectively, and include climate risk into Pillar I capital requirements. We also discuss an approach combining these two binary factors and conclude with a proposition to use ESG ratings to derive capital requirements add-ons. After all, ESG ratings take a broader perspective on sustainability and provide a more granular scale ranging from sustainable to non-sustainable rating classes. This approach ensures that green finance investments can be promoted via adjustments of capital requirements without a significant decrease of the total capital in the banking sector and, therefore, without the reduction of the stability of the financial market.