Recent papers have shown that climate risk management challenges faced by banks are reflected in the problems faced by regulators. On 30 April, the Basel Committee on Banking Supervision (BCBS) published the results of a 'stocktake' of its members' initiatives on climate-related financial risks.
Following this, on 27 May, the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) produced a technical guide for supervisors to integrate climate-related and environmental risks into prudential supervision.
These papers and our discussions show that assessing the link between climate change and operational risk is challenging. This is driven by the wide-ranging potential impacts of climate change, a lack of good data, and the longer-term view needed to assess climate change in comparison to typical operational risks, which are closely tied to relatively short-term capital and stress testing requirements. However, climate risk is a significant concern for financial institutions and regulators alike and is expected to be a focus for many years to come.
The findings of both papers closely mirror observations made by ORX following a series of recent climate risk discussions within our membership of more than 100 large financial institutions. In this analysis, we take at a look at the main findings of both papers and see how they compare to the challenges faced by banks.
What do the regulatory papers and member discussions tell us about climate risk?
4 key findings from BCBS paper on climate risk
The stocktake is the first publication from a newly established high-level group, the Task Force on Climate-related Financial Risks (TFCR). The responses from the survey of 27 Basel committee members and observers showed that:
- The majority of Basel Committee members consider it “appropriate to address climate-related financial risks within their existing regulatory and supervisory frameworks”.
- An overwhelmingly large share of members have conducted research related to the measurement of climate-related financial risks.
- A majority of members have raised risk awareness with banks through different channels, and many banks are disclosing information related to climate-related financial risks to some extent.
- Approximately two-fifths have issued, or are in process of issuing, more principles-based guidance regarding climate-related financial risks. However, the majority of members have not factored, or have not yet considered factoring, the mitigation of such risks into the prudential capital framework.
NGFS make 5 high-level recommendations
The NGFS technical guide sets out five high-level recommendations for its members, as well as the broader community of banking and insurance supervisors, to integrate climate-related and environmental risks into their work. These recommendations follow on from its 2019 study, A Call for Action, and are based on supervisors’ current practices, The five recommendations are:
- Supervisors are recommended to determine how climate-related and environmental risks transmit to the economies and financial sectors in their jurisdictions and identify how these risks are likely to be material for the supervised entities
- Develop a clear strategy, establish an internal organisation and allocate adequate resources to address climate-related and environmental risks.
- Identify the exposures of supervised entities that are vulnerable to climate-related and environmental risks and assess the potential losses should these risks materialise.
- Set supervisory expectations to create transparency for financial institutions in relation to the supervisors’ understanding of a prudent approach to climate-related and environmental risks.
- Ensure adequate management of climate-related and environmental risks by financial institutions and take mitigating action where appropriate.
What climate risk management challenges are banks facing?
Throughout the first half of the year, ORX has been running a series of regional calls to discuss the impact of climate change on operational risk management with our members. These sessions provide a platform to share views on the impact of climate change on operational risk as well as identifying common challenges and potential solutions. Specific areas that we discussed included:
- The current level of internal and external focus on climate change
- How climate change is likely to translate into operational risk
- The operational risk tools for assessing exposure to climate change
- Relevant data sources used to support assessment
It was clear that financial organisations have primarily focused on the physical risks posed by climate change. Institutions are beginning to look at the transition risks (related to the transition to a lower carbon economy) from an operational risk perspective, but this is particularly challenging primarily due to long time horizons.
Our sessions showed that the three primary risks concerning banks in relation to physical risks are:
- Physical assets – increasing weather extremes are resulting in increased damage to physical assets, building unavailability and other premises risk
- Supply chain – the supply chain and geography of services will be affected, with an expectation of seeing supply chain disruption from severe weather, potentially resulting in being unable to provide services to customers
- Infrastructure – infrastructure and IT failures, such as power outages following natural disasters
Whereas, the focus on transition risks includes:
- Conduct and legal – potential to lead to increased conduct and legal risks with increasing legal claims due to climate-related events.
- Regulation – increase in policy and regulation and changes in technological standards. This will mean an increase in compliance requirements.
- Reputational – changes in customer and stakeholder behaviour and expectations. With the expected increased pressure from regulators, media, and lobby groups to become carbon neutral, there will also be an associated cost.
7 climate risk challenges shared by regulators & banks
Challenge 1: Data availability and forecasts
BCBS stocktake findings
There is inadequate available sufficiently granular information related to climate change.
ORX climate risk calls summary
The lack of historical data makes accurately assessing climate risk challenging.
Correlating NGFS Recommendation
N/A
Challenge 2: Methodological challenges
BCBS stocktake findings
There is a lack of a harmonised and robust analytical framework for assessing climate-related financial risks which provides uncertainties in quantifying the impact of climate change.
ORX climate risk calls summary
Traditional operational risk modelling approaches are typically not appropriate, and there is a lack of a standard framework for assessing climate change. Specifically, it is difficult to reliably distinguish between climate change and natural variation in weather. It was felt that it was a challenge to attribute costs in the short term, but in the longer term the banks will need to be able to quantify the costs of climate change.
Correlating NGFS Recommendation
Identify the exposures of supervised entities that are vulnerable to climate-related and environmental risks and assess the potential losses should these risks materialise.
Challenge 3: Difficulties in mapping of transmission channel
BCBS stocktake findings
There is insufficient understanding, due to limited research so far, on how climate change and the transition towards a low-carbon economy affects specific sectors, regions, markets and consequently the financial system.
ORX climate risk calls summary
Scenario analysis is the key tool ORX members are currently using to assess climate risk. However, organisations are trying to establish whether they define climate change as a cause or a risk. Consequently, whether several scenarios will be impacted or whether it needs to be considered as a stand-alone scenario.
Correlating NGFS Recommendation
Supervisors are recommended to determine how climate-related and environmental risks transmit to the economies and financial sectors in their jurisdictions and identify how these risks are likely to be material for the supervised entities.
Challenge 4: A lack of capacity and human resources
BCBS stocktake findings
Currently, there is limited expertise within surveyed institutions to identify and mitigate the risks appropriately.
ORX climate risk calls summary
Some banks have established teams, but expertise is hard to come by and risk experts working in banks are not necessarily climate scientists so reliably making climate/weather judgments is challenging.
Correlating NGFS Recommendation
Develop a clear strategy, establish an internal organisation, and allocate adequate resources to address climate-related and environmental risks.
Challenge 5: Time horizon
BCBS stocktake findings
There is a time horizon misalignment between the ‘typical’ horizon of banks’ and supervisors’ risk analyses and the longer-term climate forecast horizon.
ORX climate risk calls summary
Changes in frequency and severity relating to climate risks are not necessarily material in the short term, particularly over the one-year time horizons used to calculate regulatory capital.
Correlating NGFS Recommendation
N/A
Challenge 6: Channels of information
BCBS stocktake findings
A majority of respondents have raised climate-related financial risks with banks through public channels. Only two jurisdictions responded that they have not raised climate-related financial risks with banks.
ORX climate risk calls summary
Many banks are drawing on data from their insurance departments such as flood risk data as well as obtaining guidance from consultancies and UN/IMF publications.
Correlating NGFS Recommendation
Ensure adequate management of climate-related and environmental risks by financial institutions and take mitigating action where appropriate.
Challenge 7: International coordination
BCBS stocktake findings
There is limited, if any, internationally-coordinated actions on the management of climate-related financial risks.
ORX climate risk calls summary
In some regions, it was felt that it can be difficult to demonstrate that firms have considered the impacts of climate change in a systematic way as changes are incremental. In other regions there is a lack of guidance for banks from regulators or government regarding climate change, leaving participants without a clear path forwards.
Correlating NGFS Recommendation
Set supervisory expectations to create transparency for financial institutions in relation to the supervisors’ understanding of a prudent approach to climate-related and environmental risks.
Limit of capital impacts in the near term
The majority of respondents to the BCBS stocktake noted that they have not yet factored, or considered factoring, the mitigation of climate-related financial risks into the prudential capital framework, with authorities in some jurisdictions unable in the short term to quantitatively assess the climate-related financial risks in the context of capital. As such, they have no immediate plans to consider applying Pillar 1 or Pillar 2 requirements for climate-related financial risks.
Our discussion calls highlighted the different speeds in which individual regulators are proceeding with the provision of guidance on climate risk. Regulators in the UK and Australia appeared the most advanced, with members in other territories looking to the UK in particular to provide an understanding of what might be expected.
Despite the lack of guidance for most, participants in the ORX calls were conducting internal climate stress testing either in preparation for increasing compliance requirements or as part of good risk management.
How will institutions respond?
There are several examples of risks that have led to the creation of separate risk management frameworks, or risk silos, because of specific regulatory focus or a need for new skills – for example, conduct risk, cyber and more recently resilience. The risks themselves can be thematic or a cause of several other risks, which can complicate the picture. Climate risk feels much like this, and it will be interesting to see how institutions respond to this regulatory focus and how it is managed within the portfolio of non-financial risks.
More from ORX on climate risk
As well as dedicated climate discussion groups, we've also explored climate risk in more detail in the Operational Risk Horizon 2020. There's also climate-related operational risk information available in our loss data and in our two premium services:
- ORX News – covers publicly reported operational risk loss events which tend to be adverse weather, reputational events, conduct and physical damage.
- ORX Scenarios – has a library of scenarios submitted by financial organisations that have mostly been developed for capital models and hence have a 1-year horizon.
