Climate-Related Prudential Risks in the Banking Sector and Emerging Regulatory and Supervisory Practices

This post is the latest in our special issue: “Climate Change and Financial Markets – Risk, Regulation, and Innovation.” To learn more about the special issue and the work of the Global Financial Markets Center around climate change and financial markets, please read the special issue’s introduction here. And to review all The FinReg Blog posts that touch on climate change, go here. 

 

As discussed in an earlier FinReg Blog post, costs associated with climate change are inevitable. As the UK Prudential Regulation Authority (PRA) summarises, climate risks are relevant to multiple lines of business, sectors, and geographies. Their full impact on the financial system may therefore be larger than for other types of risks. In addition, the time horizons over which climate risks may be realised are uncertain, and their full impact may crystallise outside of many current business planning horizons.

Costs from climate risk can be categorized into physical costs resulting from an insufficiency or lack of timeliness of mitigating action, and transition costs from moving towards a carbon-neutral economy. While banking regulators have generally been slow to respond to climate change risks, in recent years, many central banks and supervisory authorities across the world have been increasingly acknowledging that financial risks from climate change are a threat to financial stability.

Consequently, they have started to introduce regulatory and supervisory expectations with respect to banks’ public disclosure, capital planning, stress testing, and governance processes. In some of these countries, regulatory authorities have already incorporated climate risk into their supervisory approaches, actively encouraging banks to consider climate risks within their wider risk-management frameworks.

In my recent article in Sustainability with Hasan Güngör, we categorize the major regulatory and supervisory expectations regarding climate risks in the banking sector into a few key areas, ranging from identification of climate-related material exposures and disclosure of relevant key metrics to assessment of capital impact from climate risk through scenario analysis and stress testing.

Prudential supervision of climate risks in the banking sector

As shown by a recent WWF review, in many countries central banks and regulatory authorities have announced roadmaps and strategies to align their banking sector with sustainable developments and to ensure that the transition to a low-carbon economy does not adversely impact financial stability.

To give a few national examples, the Prudential Regulation Authority (PRA) in the UK has already started to require evidence that banks adequately take into account climate-related risks to their capital adequacy. In Australia, the Australian Prudential Regulation Authority encourages banks to consider climate risks within their wider risk-management frameworks. In the Netherlands, De Nederlandsche Bank has incorporated climate risks into its supervisory framework. In Singapore, the Monetary Authority of Singapore requires banks to integrate sustainability risks into their risk management frameworks. In the U.S., the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) have started expressing their supervisory expectations that banks should incorporate climate risks into their internal risk management frameworks.

At the international level, recently the Network for Greening the Financial System (NGFS), a global network established by the central banks and regulators, prompted banks to start embedding the management of climate-related and environmental risks into their enterprise risk management frameworks and processes through its guidelines for supervisors.

Proposals with respect to prudential regulation of climate risks in the banking sector

To address climate change risks, various prudential measures have been proposed to date. However, neither the Basel Committee on Banking Supervision (BCBS) nor any national regulators have introduced any binding prudential measures. While the BCBS’ Principles for the Management of Credit Risk expect banks to identify and analyse risks with respect to any product or activity, the existing prudential standards do not address climate risks. It could even be argued that the existing framework disincentivizes long-term green financing by applying a more rigorous capital treatment for long-term loans than short-term loans.

In the last few years, the idea of incorporating environmental impacts into the calculation of risk-weighted assets has been gaining popularity. Proposals include setting specific risk weights for exposures to climate risks and carbon risk industries, requiring banks to hold more capital to cover related risks and discouraging them from lending to those industries. As reviewed in a recent report by the Institute for Climate Economics, these mechanisms include Green Supporting Factor (GSF), Brown Penalizing Factor (BPF) and Green Weighting Factor (GWF).

GSF proposes to incentivize banks to grant credit to green activities by relieving capital requirements for climate-friendly projects. GBF proposes to strengthen banks’ capital base to help them overcome unexpected losses coming from “brown activities” i.e. high-carbon activities. GWF on the other hand proposes to accelerate the greening of banks’ portfolios, incentivising green loans by combining GSF and BPF.

However, these proposals are controversial and setting prudential banking regulations remains a major challenge for regulators. For instance, GSF might create a “green bubble” where a quick adjustment of loan portfolios towards green loans leads to a cliff effect (a sudden and unexpected decrease) in banks’ capital base vis-a-vis current capital requirements. On the other hand, in the absence of empirical evidence, the impact of GBF and GWF on bank loans to green and brown activities remains questionable. As a result, it currently remains uncertain whether climate-related risks will ever be incorporated into the risk-weighted assets.

Supervisory reporting and public disclosures

There is an ongoing global initiative to encourage public disclosure of climate-related financial risks under Basel III Pillar 3 framework, in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), which recommends that corporation disclose relevant climate-related financial information in their public annual reports.

Accordingly, regulatory authorities in many countries have already started encouraging climate-related financial disclosures. In a few jurisdictions, public disclosure of the potential climate-related risks and opportunities has now become a key regulatory expectation. For instance, in the UK, all listed companies and large asset owners are expected to report climate risks by 2022. In the U.S., the CFTC and the SEC have started to encourage disclosures regarding climate risks.

At the EU level, environment, social, and governance (ESG) disclosure and benchmark regulations were finalized in 2019 with the publication of the ESG disclosure regulation and low-carbon benchmarks regulation, which are the initiatives under the European Baking Authority’s (EBA) Sustainable Finance Action Plan. The plan requires banks to actively identify and manage their climate-related risks and disclose their key metrics starting from 2021.

Nevertheless, in many countries, both financial and non-financial reporting of climate risks remain incomplete, with existing disclosures generally being patchy and heterogeneous. For instance, a recent report by the European Systemic Risk Board (ESRB) explains that available supervisory reporting of large exposures of banks is not sufficient. The report argues that financial sector exposures and vulnerabilities to climate change currently involve an eclectic collection of existing supervisory data, market data sources, and various other data. The same report concludes that the existing data are incomplete, inconsistent, and insufficient to identify exposures to CO2-intensive sectors and more comprehensive granular data are required.

Climate-specific risk modelling and stress testing

While the importance of the analysing systemic risks from climate change to provide the foundations for evidence-based macroprudential policy reflections is indisputable, banks still face a major challenge in identifying appropriate data for undertaking granular financial analysis. Indeed, the BCBS’ recent survey has shown data availability among the main operational challenges in assessing climate-related financial risks.

Consequently, the majority of members on the Committee have not factored, or have not yet considered factoring, the mitigation of climate-related risks into the prudential capital frameworks. The same survey has also revealed that there remain difficulties in mapping of transmission channels of climate-risks in the absence of supervisory guidelines on how banks should conduct scenario analyses to assess the impact of financial risks arising from climate change.

In a few jurisdictions such as the Netherlands and the United Kingdom, stress testing banks for climate risks has already been on the top of the regulatory agenda. In the Netherlands, De Nederlandsche Bank has already incorporated climate risks into supervisory frameworks and stress testing, having conducted the first climate-related stress testing in 2018. In Canada, the Bank of Canada has incorporated climate risks into its analysis of the Canadian financial system and published a Climate Change Scenario Analysis study. In Singapore, the Monetary Authority of Singapore plans to include climate-related scenarios in industry-wide stress tests.

Similarly, the Bank of England (BoE) incorporated climate risks into its prudential supervisory framework in 2019 and plans to include climate risk scenarios in the sector-wide stress tests in 2021. The regulator expects banks to start incorporating climate-related risk factors in their risk modelling frameworks to understand the short- and long-term financial risks to their business model and capital adequacy. The BoE also requires banks to develop their own scenarios and to calibrate them based on the general practice and experience in the industry. It also expects banks to identify the factors that may impair asset values, increase credit risks, and reduce the value of their investments.

In the EU, the EBA has also considered developing dedicated climate change stress tests. However, it has not published specific details yet. Specific requirements and variables with respect to stress scenarios are likely to differ depending on the assessment of the national regulators. While the EBA has provided clarification on where action is needed from banks, it is expected to publish further discussion papers, technical standards, and further guidance by 2025 with respect to scenario analysis.

Conclusion

Development of banking regulations with respect to climate risks is still in progress across the world, with further work needed on the quantification of related risks, clarification of data gaps, and identification of relevant transmission channels. However, regulators in some jurisdictions have already started to expect banks to act on climate-related risks without waiting for the related rules to be finalised.

Given the changing regulatory landscape, banks would be well advised to start incorporating climate change into their risk management frameworks and strategic planning by assessing their current loan portfolios and banking operations for any physical and transition impacts. In particular, they should start monitoring climate change risks on an ongoing basis ensuring that their capital sources remain adequate to mitigate relevant risks.

 

Mete Feridun is a Professor of Finance at Eastern Mediterranean University and formerly a regulatory risk and strategy consultant at PwC UK, as well as a senior regulator at the Prudential Regulation Authority, Bank of England and the Financial Conduct Authority in the UK.

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