Integrating ESG Risk into the Banking Prudential Framework in EU: The Impact on SMEs

Chapter 3 examines the integration of Environmental, Social, and Governance (ESG) risks into the EU banking prudential framework, focusing on its impact on SMEs. Banks are crucial for SME financing, influencing their growth and sustainability. The chapter highlights how bank market power and firm characteristics can affect credit constraints for SMEs, depending on regulatory environments and strategic goals. Private and Islamic banks, along with fintech innovations, offer flexible financial solutions tailored to SMEs, as seen in Indonesia. However, extensive regulations, including capital reserve requirements and compliance with anti-money laundering (AML) and counter-terrorism financing (CTF) laws, complicate lending processes and increase costs. Macroeconomic conditions and market demand shifts also impact lending. The chapter concludes by proposing solutions to improve SME access to funding, enhance credit risk assessment, and streamline compliance, aiming to support SME growth and economic stability.