How to address climate risk in the banking prudential framework

Wed 20 Jul 2022

Climate change is now firmly in the focus of prudential regulators and supervisors across the globe. Against this background, the European Banking Authority (EBA) is mandated to assess whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and social objectives would be justified. Based on its findings, the EBA shall submit a report to the European Parliament, Council and Commission by 28 June 2023, taking into account any Basel Committee on Banking Supervision (BCBS) policy recommendations in the meantime. The final report might trigger a Commission legislative proposal introducing climate-related risks in Pillar 1 of the prudential framework.

The banking sector is particularly exposed to climate-related risks

The role of prudential policy is to ensure the soundness of the banking sector so that it can continue to finance the real economy. Yet achieving net zero will not be possible unless societies make major investments in developing new technologies and signficant changes across the economy. A sound banking system can support households and businesses through these changes and channel investment to support this huge transition. However, even in a benign economic environment, it will be a major challenge. The ability to withstand physical risks like flooding, extreme weather events, and transitional risks that arise as the economy shifts away from carbon-intensive activities will be vital for banks reliant on a safe and sound financial system.

The role of environmental risk drivers in the prudential framework

Climate change will inevitably create losses for banks, even in a scenario where governments around the world take swift and early action to bring us to net zero. Banks must therefore have the resilience to keep serving the real economy in the face of these losses, which suggests climate risk could be captured in capital requirements. This raises the question of whether the prudential framework can sufficiently account for these new risk drivers, or if adjustments to the existing framework may warrant a dedicated treatment for such risks.

Some have long argued that policy measures may be desirable to ensure banks contribute to the transition towards a carbon-neutral economy. The so-called green supporting and brown penalising factors, resulting in a capital reduction or surcharge on assets, were specifically designed to serve this purpose. However, the EBA has not considered these factors since it sees the framework as remaining primarily risk-based. The EBA says that prudential requirements should reflect the risk profiles of exposures and should not be used for other policy purposes

Accordingly, when considering a dedicated treatment of environmental risk drivers, one should first evaluate the extent to which these are already reflected in the prudential framework. Thus, due consideration should be given to these fundamental questions:

• Does the current design of the system allow for the handling of Environmental Society and Governance (ESG) risk drivers?
• Will the self-updating nature of the framework be sufficient?
• Does it reflect the forward-looking nature of environmental risks?
• What would be the overall level of capital in the banking sector?

In its preliminary analysis, the EBA states that the framework already includes provisions that allow for the inclusion of new risk drivers, such as those related to environmental risks. These include internal models, external credit ratings and valuations of collateral and financial instruments. Targeted amendments to the existing prudential requirements would address these risks more accurately than simple adjustment factors, given the various challenges associated with their design and implementation.

Value in leveraging the existing framework

The EBA has identified several areas of the prudential framework where amendments to better address climate risk would be desirable.

In a standardised approach for credit risk, three aspects would be explored: external credit assessment, due diligence and valuation of collateral. This may also be looked at more granularly on risk weightings. For Internal Ratings Based (IRB)-banks, some flexibility already exists for incorporating new risks in the IRB approach, subject to conditions such as model performance, data representativeness, and possible conservatism in model application. In particular, collateral valuation can be reflected in loss given default (LGD) estimates and regulatory LGD values. For specialised lending exposures, a slotting approach can embed environmental drivers. Adapting the risk-weight function could also be considered.

On a standardised approach for market risk: further granularity of risk weights or risk factors may be considered for the sensitivity based approach (SBA); on default risk charge (DRC), similar considerations as for credit risk; and possible use of the residual risk add-on (RRAO)^[1] to address environmental risk by also extending to simple trading book instruments. As for the internal model approach, two aspects could be envisaged. First, capturing environmental risk outside of the model through an add-on based on scenarios not historically observed. Second, incorporation in the existing capital adequacy of stress-testing programmes.

From an operational risk perspective, environmental factors fall within the existing categories of operational losses, such as physical damage, interruption of services or litigation processes. The EBA considers that operational loss data should explicitly identify environmental risk factors. In addition, reputational risk in Pillar 2 may be significantly affected by environmental risk factors.

Finally, reporting requirements related to the largest exposures subject to environmental risk and potential new limits may be considered as well as the current treatment of concentration risk on a sectoral or geographical basis within Pillar 2.

What are the limits?

One may argue that for the time being, altering banks’ capital requirements is not the best tool to address the causes of climate change; for example by reducing capital requirements to subsidise green assets or increasing them to penalise carbon-intensive ones. By diverting the capital framework from its core goal of keeping the financial system safe and sound, we might end up under-capitalising banks for the risks they face, raising questions about their overall resilience. Or we could end up over-capitalising them inefficiently, reducing their ability to support the economy through the transition.

There is little evidence that fine-tuning capital requirements in this way would actually achieve its intended goals. There are two kinds of gaps we primarily might need to fill.

On the one hand, “regime” gaps occur when the design, methodology or scope of the capital framework does not adequately cover climate risks. Some aspects of the Pillar 1 capital framework use a one-year time horizon for calculating potential unexpected losses as a modelling assumption. While it may be reasonable for many risks, it seems particularly ill-suited for climate change; a risk structurally building over time and will not fully materialise over a one-year horizon. On the other hand, there are “capability” gaps where firms and regulators do not have the data and modelling abilities to ensure climate risk is appropriately captured. This is a major challenge since climate risk is very different from traditional financial risks and impossible to rely on historical data to assess. Plus, the largely backwards-looking traditional approach based on historical loss experience would probably fail to capture the forward-looking elements of these risks.

Pillar 2 seems more appropriate to tackle climate risk

In the prudential framework Pillar 1, requirements are complemented by Pillar 2 additional own funds requirements, which are based on the institution-specific analysis performed by competent authorities. This way, Pillar 2 allows appropriate recognition of different business models and specific risks. Therefore, in the context of the analysis of the idiosyncratic aspects of environmental risks, even if they are not partly or fully covered by Pillar 1 own funds requirements, they could still be addressed through Pillar 2.

Lessons learnt from the Covid-19 pandemic show that the prudential status of the banking system is solid enough to withstand a major unexpected shock. Due to the rigidity of the current prudential framework, regulators promptly enacted a regulatory quick fix for easing off Pillar 1 measures to let banks play their role as part of the solution.

Instead, banks could complement existing credit assessment processes with ESG-related assessments. Risk assessment processes could also include forward-looking information such as companies’ investment plans as well as transition plans. Moreover, climate risks can, to a large extent, be mitigated if the transition is handled in an orderly, transparent and controlled manner. Consequently, carbon-intensive activities will be gradually reduced alongside the financing of such activities.

Firms need to understand at a granular level how their balance sheets and business models are exposed to both present and future climate risks so they can take the right risk management actions today. This includes investing in their data and modelling capabilities, and carefully scrutinising the data they get from third parties. It means ensuring boards and senior executives see climate risk as a strategic priority and ultimately ensuring firms hold sufficient financial resources to absorb losses arising from climate change.

^[1] In the FRTB : SBA is the sensitivity based approach, DRC the default risk charge and RRAO the residual risk add-on.