The global standard setter for banking regulation, the Basel Committee on Banking Supervision (BCBS), has published guidance on how banks and supervisors should address climate risk.
It contains 18 principles (12 for banks themselves and six for regulators) outlining how banks should factor climate changes into corporate governance, risk assessment and internal controls.
This is a further step towards the integration of awareness of systemic climate risk into financial activities and is a significant step towards mainstreaming the need for a net zero transition.
Central banks to address climate risk
There has been growing pressure for clarity on the role of the financial sector, both in addressing climate change and in terms of building resilience to the potential physical and policy risks associated with climate change.
As the banking supervisory authority, the BCBS is made up of central banks and other regulatory authorities, with 45 members from 28 jurisdictions and its guidance effectively outlines the baseline for how the financial system ought to behave, through the policy recommendations of the Basel Accords.
This announcement follows the closure of its consultation period in February 2022. Of course, the announcement of the principles is not going to stop the ongoing debate as to whether or not their actions go far enough.
Climate scenario analysis and stress testing
Supervisors have, however, now been tasked with considering climate scenario analysis or stress testing (as recently undertaken by the Bank of England) in order to test the resilience of domestic banks to climate change-related risks.
While stress-testing for macroeconomic issues has a solid history, criticism of such processes remains for climate change, not least because there is little historical data from which comparisons can be drawn.
Traditional macroeconomic stress-testing is often undertaken for a period of nine quarters, while climate stress-testing employs scenarios imagining what the next 30-50 years will bring.
Other challenges include a lack of data on how counterparties might behave in the future, as well as often basing projected performance on little change in bank behaviour (in terms of hedging risk).
That said, directing banks to integrate awareness of climate risk into forward planning, including material climate risks into internal capital and liquidity adequacy assessment, is a major step forwards in terms of realigning capital towards more sustainable growth.
Basel III Accord set international standards for banking resilience
Outside the banking world the BCBS, and the Basel III Accord in particular, are best known for its role in setting international standards for bank capital adequacy levels, stress-testing and liquidity requirements, implemented following the financial markets collapse of 2007-2008.
It was designed to ensure that banks retained sufficient resilience to market shocks, in order to mitigate the risk of collapse of the international banking system and focuses on the leverage ratio, effectively looking at levels of banks exposure to a particular problem and whether they can effectively respond to sudden short term calls on capital.
The Basel III reforms were intended to ensure that the banking system could survive a sudden market downturn.
It’s not just scenarios and stress testing that are suggested, though. Part of the guidance refers to the need for banks to include climate-related risks in their internal controls, and to ensure that internal risk controls factor in climate issues.
In fact, according to the BCBS, “The principles seek to achieve a balance in improving practices related to the management of climate-related financial risks and providing a common baseline for internationally active banks and supervisors, while maintaining sufficient flexibility given the degree of heterogeneity and evolving practices in this area.”
Banking guidance on climate risk
There is a groundswell of action in terms of climate risk.
It’s worth noting that in North America, Canada’s Office of the Superintendent of Financial Institutions (OSFI) issued a new draft guideline in May 2022 setting expectations for federally regulated financial institutions along the recommendations of the TCFD, while the US SEC’s comment period on climate risk reporting finally closed in June, with the results eagerly awaited.
A spokesman for OSFI said that “this guideline proposes a prudential framework that is more climate sensitive and recognises the impact of climate change on managing risk,” and suggests that changes to capital requirements (as outlined by the BSCB) are likely further down the line.
In the UK, the Financial Reporting Council (FRC) has said it is consulting on potential changes to actuarial standards, in order to factor in both climate and ESG risk.
The decision was made on the back of research that shows that emerging risks are not being considered in as much detail as established and well-understood financial risk.
Its proposal would ensure that practitioners “have regard to all material risk, including the consideration of climate-related risks, which they might reasonably be expected to know about at the time of carrying out their work.”
Such changes, if accepted, will have an impact on auditors, accountants and actuaries, all of which are regulated by the Council. Comments are open until 7th September 2022.
With increasing focus on double materiality and the impact of operations on the environment and society becoming increasingly visible, banks, insurers and other financial institutions are going to need to start working more effectively in addressing climate risk.
Significant data and skills gaps remain, but it appears that climate and ESG risk management are the new normal.