Finding the right place for Climate Risks in regulatory capital frameworks

The nature of the climate's tipping points and feedback loops makes historical data a poor predictor of how climate risks affect enterprise gains and losses in the future. It stands to reason that physical climate risks may change the "shape" of loss distribution functions, affecting their mean and/or variance.

Moreover, transition risks may also exert a negative impact on these loss distribution functions. For example, the ECB warns that the euro area banking system may be exposed to tail risks in the event of sudden changes in carbon prices if companies do not reduce their emissions speedily enough.

Indeed, losses borne by the financial system could result in less lending by banks and indemnity coverage by insurers, which in effect could mean widespread reductions in their support to the real economy. As both physical and transition climate risks pose a material threat to the banking and insurance sector, there is a growing consensus among policymakers and supervisors that they may even be a source of systemic (so-called macroprudential) risk to the financial system as a whole. This has fuelled debates and efforts to examine whether the existing regulatory frameworks can adequately capture these risks.

The existing regulatory capital frameworks already account for climate risks to an extent, for instance, through credit and market risk in the banking framework. However, the difficulties in estimating climate risks means that this risk capture may be incomplete.

While the ECB's economy-wide climate stress tests already use climate scenarios to help model the interplay between transition and physical risk over the next 30 years, the bank started examining the adjustment of its prudential framework to capture the special features and amplifiers of climate risks. Having concluded late in 2021 that no euro area bank is close to meeting all supervisory expectations on climate and environmental (C&E) risks, the ECB spent the first half of 2022 carrying out a full review of how adapted banks are to manage related risks, in tandem with its supervisory stress test on climate-related risks.

The results, published in November, indicate that euro area banks are still far from managing these risks at a desired level. For this reason, the ECB has set staggered deadlines to progressively meet all the supervisory expectations laid out in the 2020 Guide on climate-related and environmental risks.

To begin with, the ECB wants banks to adequately categorise C&E risks and to run a full assessment of their impact on the banks' enterprise by March 2023. Secondly, by the end of 2023, banks will have to include C&E risks in their governance, strategy and risk management. While some progress is noted, the ECB bemoans a prevailing "wait-and-see approach." Lastly, by the end of 2024, banks must meet all remaining supervisory expectations on C&E, including full integration in the Internal Capital Adequacy Assessment Process (ICAAP) and stress testing.

While these deadlines are related to Pillar 2, amending Pillar 1 requirements is not out of the question. The latter framework is "currently being examined to make sure it adequately addresses climate-related and environmental risks," reminded Anneli Tuominen, Member of the Supervisory Board of the ECB, in September. A European Banking Authority discussion paper has been published on this topic, and discussions within the Basel Committee on Banking Supervision are ongoing.

The ECB is thus taking decisive action. "There can be no more questions about responsibilities. Banks must have risks fully measured and priced," says Frank Elderson, Member of the ECB's Executive Board.

Apart from weighing in on the macroeconomic and monetary implications of climate change, the Bank of England and the Prudential Regulation Authority (PRA) are occupied with the impact on the financial sector and stability. As laid out in the PRA's Climate Change Adaptation Report 2021, the UK capital framework could be a helpful tool to ensure that PRA-regulated institutes are resilient to climate risks. However, the authority states "it is not a given that changes to the capital frameworks will be required as the risks might already be adequately addressed in the capital regime" or could be handled through the embedding of supervisory expectations on climate-related risks and improvements to accounting and disclosure.

While the PRA strives not to draw any foregone conclusions, it wishes to provide more guidance on its approach to climate and capital by the end of 2022. In an effort to inform the debate, it held the Climate and Capital conference in October.

The event featured a multi-perspective discussion on where climate risks would be optimally reflected in the capital framework, with contributions from scholars and regulators, including the Bank of England, Nationwide Building Society, ECB, and Institute of International Finance, and the Council on Economic Policies.

On one hand, it can be argued that climate risks make themselves evident through traditional risk channels and should thus be naturally captured by parts of the firm-specific microprudential regime. The question would then be not whether risks should be reflected in these parts of the framework but rather if they are already adequately captured. Tools would then concern risk-weighted assets calculations and potential increases in the minimum capital requirements.

On the other hand, should some climate risks not be captured within the current microprudential framework, then macroprudential regulatory changes could enter the scene. For example, an alternative to increasing the minimum capital requirement would be to make changes to Pillar 2, i.e. bank-specific recommendations indicating the level of capital the central bank expects banks to hold above their binding capital requirements. Moreover, a macroprudential policy response may put emphasis on a uniform macroprudential approach to systemic climate risks so as to preempt possible spillovers between the banking and non-banking sectors. Solutions may entail novel hybrid instruments combining borrower-based exposures and a systemic risk buffer.

The Bank of England admits in a summary that there exists research favouring both micro and macroprudential elements as well as neither — it could be argued that present levels of uncertainty should lead banks and insurers to focus on building their risk management capabilities spanning from valuation and accounting to other means of risk capture and measurement, gradually being translated into microprudential tools.

Weighing different research and arguments will be a laborious task. It remains to be seen what policy proposals the PRA will revert with. One thing remains certain: Banks' risk management will change one way or the other.

According to the ECB, while 85 percent of the reviewed banks now have in place at least basic practices in most related areas, less than 10 percent of institutions use sufficiently forward-looking and granular climate and environmental risk information in their governance and risk management practices.

Thankfully, ways out exist. Quantifying and understanding risks is key for financial institutions to build resilience in high-risk areas and be better prepared for the implemented regulatory adjustments.

Get in touch with our team and discover how you can leverage our climate risk platform Spectra to assess the potential risks to your assets and portfolio posed by the progressing warming of the climate and the costs of net zero transition.