Climate change has quickly ascended to the top of banks’ long-term risk agendas; is the regulatory landscape driving the pace?

Christopher Woolard CBE
Partner at EY, EMEIA lead financial services regulation, Chair EY Global Regulatory Network. Trustee at Which?

The regulatory landscape in relation to climate and wider sustainability is a complex space. Though stakeholder approaches are coalescing in some areas, regulation and policy continue to evolve rapidly. Firms are facing challenges, both in terms of practical application and growing regulatory and supervisory oversight.

As climate risk is an unprecedented threat, accurately capturing its impact on bank balance sheets poses a major challenge and necessitates innovation in forward-looking modeling, scenario analysis and data granularity.[1] Climate-related risks are inherently more complex and long-term than most traditional business risks. There is a growing consensus among policymakers and supervisors that climate change poses real financial risks. Recent work by the Financial Stability Board (FSB) has also focused on how climate risks might impact, or be amplified by, the financial system.[2] This will be the main driver for any adjustments to the prudential framework.

In the past 18 months, we have seen climate change quickly ascend to the top of banks’ long-term risk agendas. Bank boards and senior management must remain resilient across a broader set of dimensions. As the world adapts to a post-COVID-19 world, banks’ purview will now need to include climate-related risks, as well as other environmental, social and governance matters, in order to be sustainable for the long-term. In 2021, EY teams and Institute of International Finance (IIF) risk management survey found climate change to be a top concern for banks, with over 90% of banks’ chief risk officers viewing climate change as the top emerging risk in the next five years.[3] It will be interesting to see how this compares a year on in the 2022 EY and IIF survey, which is due to be published later this year.

Climate-related risks are inherently more complex and long-term than most traditional business risks. It refers to the set of potential risks that may result from climate change and could potentially impact the safety and soundness of individual financial institutions (FI) and the financial stability of the banking system.[4]

Climate change affects the financial system through two main climate risk drivers. Physical risk, which refers to the financial impact of changes in climate (e.g., cyclones, droughts, heat waves or floods), and transition risk, which refers to an FI’s financial loss from adjusting to a lower-carbon and sustainable economy.

Climate change's unprecedented threat means that accurately capturing its impact on bank balance sheets poses a major challenge and necessitates innovation in forward-looking modeling and granular data.[5] Finding solutions to address this gap is firmly on the regulatory agenda and is rapidly moving at pace.

What are the regulators saying around the globe?

Globally, regulators and supervisors have launched initiatives looking into whether the current banking framework can adequately cover climate risk; however, some jurisdictions are yet to review their prudential frameworks in relation to climate change. The Basel Committee for Banking Supervision (BCBS) published its final 18 principles for the effective management and supervision of climate-related financial risks, which may trigger further action at a more local level; it covers:

1.      Corporate governance

2.      Internal controls

3.      Capital and liquidity adequacy

4.      Risk assessment: credit, market, liquidity, operational

5.      Risk management and reporting

6.      Scenario analysis

They seek to achieve a balance in improving risk management and supervisory practices and providing a common baseline for internationally active banks and supervisors.[6] The approach builds on the review of the current Basel Framework (specifically Basel Core Principles (BCPs) and Supervisory Review Process (SRP)), considering a potential course of action to accommodate additional responses to climate-related financial risk. Separately, recent work by the FSB has focused on how climate risks might impact, or be amplified by, the financial system.[7] Such initiatives will be key drivers for any adjustments to the prudential framework.

Within major markets, momentum to address climate change is building. In the Asia Pacific, Japan and China have pledged to go carbon neutral in a few decades, while Hong Kong has taken steps to regulate climate-related risks. In July 2021, the Hong Kong Monetary Authority issued its “Guidelines on the management of climate-related risks by Authorized Institutions (AIs),” incorporating leading international standards and practices.

In addition, the European Banking Authority (EBA) published a discussion paper on the role of environmental risk in the prudential framework, assessing how Pillar 1 can be adapted to accommodate such risks. The EBA examines its own fund requirements for credit, market, non-financial and liquidity risks, addressing challenges around data availability, forward-looking characteristics and add-on treatment constraints.[8] The final report is expected to be delivered in 2023, and further analysis on Pillar 2 and 3 is currently being evaluated.

Meanwhile, the US Securities Exchange Commission recently proposed rule changes that would require registrants to include climate-related disclosures, including information about climate-related risks that are likely to have a material impact on business operations. In the UK, the Bank of England climate stress test results indicate that UK banks could endure a drag on profitability if they are unable to manage climate risks effectively.

Key considerations for banks

·        Banks need to take a rounded view of climate as a risk — this includes reputational — but there is a major question of climate as a financial risk.

·        Climate risk capabilities should be developed in terms of data and methodology to quantify risk exposures, transmission channels and impacts to capital requirements.

·        A sound risk management process should reflect both roles and responsibilities, along with operations that support the identification, measurement, analysis and reporting of climate-related financial risks.

·        Differentiation between climate change as a financial risk, a reputational risk, and a corporate social responsibility issue needs to be clear and reflected in the allocation of roles and responsibilities.

·        Climate risks and opportunities should be front and center as organizations plan their future growth strategies and report progress.[9]

·        If not already, embed climate-related risks into strategy, governance, risk management, disclosures and reporting now. The use of forward-looking scenario analysis and internal stress testing should be included.

·        Scenario analysis is essential for organizations to understand the physical, economic and regulatory connection between future climate impacts and business and supply chain activities.

Conclusion

As of the end of the UN Climate Change Conference (COP26) in November 2021, more than 1,000 companies had set 1.5°C-aligned science-based targets[10], and, to date, 97 banks from 39 countries —representing $66 trillion in total assets, or 43% of all banking assets globally — have joined the Net-Zero Banking Alliance.[11]

Regulators and supervisors are increasingly showing how serious they are about the potential impact global warming could have on the stability of the banking sector.

While a common ground on how to address climate-related financial risk is still being disputed among regulators, particularly in terms of its own fund requirements, it is evident that these will probably be incorporated into capital and liquidity adequacy assessment over time as methodologies, data and risk analysis evolve. Accordingly, the banking sector should start building climate risk capabilities and develop risk indicators and metrics to quantify exposures and assess impacts to traditional financial risk types.

With the geopolitical, societal and regulatory landscape moving at a rapid pace, the focus is shifting onto what role broader environmental risks, as well as the “S” in ESG, have. This highlights that other areas of sustainability are starting to garner more focus.

Disclaimer: The views reflected in this article are the author’s and do not necessarily reflect the views of the global EY organization or its member firms.