How to start implementing the BCBS Principles for effective management and supervision of climate risks
The introduction of the Principles for effective management and supervision of climate related risks by the Basel Committee on Banking Supervision (BCBS) are largely aligned with the recommendations of the Taskforce on Climate-related Financial Disclosures and EBA’s Report on management and supervision of ESG risks. ESG risks have a significant impact on financial institutions with basically all departments and many internal processes being affected.
The principles are currently for consultation and are mainly addressed supervisors, but practically also apply for financial institutions. Implementation of the principles will require time and effort, not to mention funds to incorporate them. The principles can have a potential impact on Pillar 2 capital requirements, strategies, policies etc., but financial institutions might not have started to address the different tasks ahead. The following reflections give an overview of the different implications and consequences the introduction of the principles will have on financial institutions.
Governance & Compliance
Board and Senior management should have an adequate understanding of ESG, identify and assign responsibilities within the organization and exercise effective oversight. Furthermore, financial institutions should ensure that material physical and transition risk drivers are taken into consideration when developing and implementing business strategies. These responsibilities will require amendments to not only the organisational structure, committee charters, job descriptions and reporting requirements, but also to internal training schemes for Board, Senior Management and all other staff affected in the organisation. In addition, Board and Senior Management shall ensure that climate-related risks are incorporated in all three lines of defense.
- Ensure that Board and Senior Management have an adequate understanding of climate-related risks
- Identify and assign responsibilities for climate-related risk management throughout the organisation and exercise oversight
- Incorporate material physical and transition risks and relevant sub-risks in business strategies and risk limits etc.
- Safeguard that Senior Management/the Board possesses the necessary skills and experience as well as an understanding of climate-related financial risks
- Consider which risk mitigation measures for ESG that are in line with the financial institutions’ internal requirements and those which need to be adjusted
- Define, re-calibrate and approve risk appetites regarding the institutions’ credit, market, liquidity and operational risk given the impact from climate-related risks
- Qualify and quantify the potential impact from climate-related risk on ICAAP and ILAAP requirements
First line of defense
Businesses shall undertake climate-related risk assessments during the client onboarding and credit review processes. Frontline staff should have sufficient awareness and understanding to identify potential climate-related financial risks, which will require training efforts and potentially new recruitments, but shall also be able to develop internal guidelines, rating tools etc. It is also recommended that financial institutions start engaging clients and counterparties in order to collect additional data so that they can develop a better understanding of their transition strategies and risk profiles as well as to assess ESG-related risks.
The Procurement function (also applicable for the other departments) will also be affected. Financial institutions will have to evaluate their supply chains, considering if office suppliers (paper etc.), providers of travel services or utility companies (e.g., energy, heat, and water suppliers) meet the financial institution’s expectations and make decisions on replacing suppliers which no longer qualify.
For the HR function there will be amendments required (also applicable for the other departments). Significant investments in climate-related risk trainings and staff developments will be necessary and the function shall also continuously ensure that employees have the required knowledge and are up to date with recent developments. Due to lack of internal competences, the hiring of new staff with specialized knowledge will most likely be required in all financial institutions.
- Assess climate-related risks during the client onboarding (e.g., KYC) and credit review processes
- Evaluate supply chains to see if these meet the expectations
- Invest in climate-related risk trainings and ensure that required knowledge exists
- Hire new staff
- Review of guidelines, management frameworks, rating tools and authorization structure
Second line of defense
The second line of defense shall independently undertake climate-related risk assessments and monitor, and challenge, the initial assessments conducted by the frontline. They shall also develop qualitative or quantitative metrics or indicators to assess, monitor, and report climate-related financial risks.
Compliance shall ensure identification and adherence to applicable climate-related rules and regulations.
- Assess and monitor climate related risks
- Develop qualitative or quantitative metrics / indicators to assess, monitor and report climate related risks
Third line of defense
Internal Audit is obliged to carry out regular reviews of the overall internal control frameworks and systems in light of changes in methodology, business and risk profile, as well as in the quality of underlying data, triggered by the incorporation of climate-related risks.
- Review internal control frameworks and systems regarding methodology, business and risk profile as well as the quality of the underlying data
Risk Management Framework
The institution’s Risk Management Framework will also have to undergo major changes in order to manage climate-related risks. The risk inventory must be amended to include climate-related risk drivers which will trigger an update of all processes for risk identification, assessment, control and reporting of traditional risks.
- Secure clearly articulated risk policies and processes to address material climate-related credit risks
- Start building risk analysis capabilities by identifying relevant climate-related risk drivers, developing key risk indicators and metrics to quantify exposures to these risks
- Identify, monitor, and manage all climate-related financial risks that could materially impair the bank’s financial condition, including capital resources and liquidity positions
- Conduct scenario analyses and stress tests to reflect relevant climate-related financial risks, which should include the physical or transition risks that are relevant to the institution’s business model, exposure profile and business strategy
Short- and long-term impacts from climate-related risks will impact the credit risk profile of a financial institution. Existing models and processes for assessment and quantification of credit risk, for example PD and LGD, must be amended considering climate-related risk drivers.
For PDs, it is often concluded that the new risk drivers will have an impact over the longer term and that models predicting risk over the next 12 months are rarely affected. This might be generally true for risks related to climate changes, but when it comes to demand driven changes (such as changes in customers’ views on sustainability) these might also impact firm’s survival in the short run. Firms no longer meeting customers’ climate-related preferences will see that demand is rapidly reduced, even if the climate changes have not yet materialized.
The LGD can, especially for long-term loans, become affected. Real estate collateral, for example, might no longer be able to be insured, or only at a very high cost, if the geographical locations are especially vulnerable to climate changes. Properties near the sea, for example, may be vulnerable to flooding if the sea level increases and properties in valleys may be vulnerable to flooding in periods with heavy rainfall.
Changes to Loan Loss Provision models come with significant complexity as for long-term loans. The lifetime calculation requires long-term forecasts of PD and LGD where there is a considerably larger likelihood of real climate change related impacts.
- Amend existing models and processes for the assessment/quantification of credit risk considering climate-related risk drivers e.g., regarding PD and LGD
- Adjust LLP-models as the likelihood that climate change related impacts materialise is significantly higher for the calculation of lifetime PDs for long-term loans
Climate-related risks can have a direct impact on the bank’s operational risks, for example compliance risks where new climate-related requirements and regulations must be identified, assessed and properly implemented. Furthermore, financial institutions should assess the impact of climate-related risk drivers on their operations in general and on their ability to continue to provide critical operations. Financial institutions are expected to analyse how physical risk drivers can impact their business continuity and to take material climate-related risks into account when developing business continuity plans.
- Identify, assess and properly implement e.g., new requirements and regulations regarding compliance
- Assess the impact of climate-related risk drivers on financial institutions’ operations and ability to continue providing critical operations
- Analyse the impact of physical risks on business continuity
- Take climate-related risks into account when developing business continuity plans
IT- and Information Security Risk
Financial institutions have to ensure that internal reporting systems are capable of monitoring material climate-related financial risks and producing timely information, to ensure effective board and senior management decision-making. Risk data aggregation capabilities should include climate-related financial risks to facilitate the identification and reporting of risk exposures, concentrations, and emerging risks.
- Adjust or develop internal systems to enable that required data can be entered, and ensure that this data is also being requested from customers
- Adjust tools and systems e.g., the introduction of ESG related risk factors in the analysis, in risk ratings and LGD as well as lifetime PD calculation (ICT/Group Risk Management etc.)
- Aggregate climate-related risk data and facilitate identification and reporting of risk exposures, concentrations, and emerging risks
Market and Funding Risk
The impact climate-related risks have on market risk is obvious for investments in equities and fixed income instruments, where the issuers are sensitive to the new risk drivers. Equity prices can quickly be affected and bonds issued will depreciate due to widened credit spreads. FX rates can be affected if larger economies with their own currency are not shifting over to climate-neutral energy sources and demand for their export is affected by changes in customer demands or import tolls by countries fulfilling higher environmental standards.
In evaluating mark-to-market exposure to climate-related risks, institutions should consider how pricing and availability of hedges could change given different climate and transition pathways, including in the event of a disorderly transition. Financial institutions should understand the impact of climate-related risk drivers on their market risk positions and ensure that market risk management systems and processes consider material climate-related financial risks.
Furthermore, financial institutions should assess the impacts of climate-related financial risks on their funding capabilities. Net cash outflows (e.g., increased drawdowns of credit lines, accelerated deposit withdrawals) or the value of assets comprising their liquidity buffers shall be assessed in the light of the new risk drivers. In addition, the ability to remain sufficiently capitalised must be evaluated. Through the liquidity adequacy assessment processes (ILAAP) and internal capital adequacy assessment process (ICAAP), a financial institution shall evaluate the impact from climate-related risk drivers on their liquidity and capital position. The required stress testing must also be amended, and recovery plans (also applicable for other departments) must be reviewed in the light of these new risk drivers.
- Evaluate if a scenario analysis incorporating climate-related risks will be beneficial for the financial institution in terms of providing a better understanding of risks
- Assess the sensitivity of equities, fixed income instruments and FX-rates etc. regarding climate-related risks on overall market risk positions
- Define thresholds when Treasury/Financing need to act given reduced liquidity in line with net cash outflows
- Assess how climate and transition risk might impact funding costs and different sources of funding
- Evaluate the impact of climate-related risks on liquidity and capital position of a financial institution
The outlined reflections show that the introduction of the Principles for effective management and supervision of climate related risks require significant effort as well as notable financial resources by financial institutions as supervisors will follow up on the incorporation of the principles. Budgets need to be approved and funded, and processes documented and approved.
We are of the opinion that institutions with prepared approaches, considerations and incipient practices regarding ESG, even on a modest scale, are in a good position to engage in supervisory dialogue for their benefit. It does not necessarily necessitate highly data driven modelled outcomes. The most valuable decision at this point would be to make a commitment and start doing the work, piece by piece.