Learning by doing: Climate risk & your 2021 ICAAP

As we roll into 2021, financial services firms that run an internal capital adequacy assessment process (“ICAAP”) will be reviewing their risk registers for adverse risk factors and scenarios to anchor the assessment on.1 In the current fairly unstable macro-financial environment, the long list of risks that merit attention in the ICAAP continues to grow. COVID-19 macroeconomic implications, BREXIT, low interest rates are prominent contenders for ICAAP inclusion, as are several others. Some firms hold the view that climate risks lack the same immediacy and without complete guidance on how to run climate change risk analysis, there is ambiguity about the level of analysis to be included in the ICAAP. However, we make the case that there is urgency to the climate change agenda, also backed by regulatory expectation, which merits the prioritisation of climate risks in the 2021 ICAAP.

Done well, good ICAAP analysis:

• Identifies key risks to the business;
• Comments on their materiality along different dimensions – such as likelihood, impact and velocity;
• Includes scenario analysis that illustrates how some or all of the identified risks might play out over the planning horizon;
• Provides supporting qualitative and quantitative impact analysis, typically under both a base and select stress scenarios;
• Outlines the bank’s response to the risks, especially under the stress scenario; and, in doing so
• Demonstrates the bank’s overall risk management capabilities and the consequent implications for risk strategy and capitalisation.

 Banks and other financial service firms that prepare ICAAPs would recognise these design principles. Furthermore, firms reporting to the PRA or European Regulatory Authorities on their ICAAP will be tracking the increased regulatory expectations on climate risk, notably the ECB and PRA comments in recent months, as clarified in the PRA’s Dear CEO letter and ECB’s report on banks’ ICAAP practices. Despite the regulatory drivers, some institutions may still have reservations about prioritising climate risk in their ICAAPs. These concerns could range from doubts about general readiness to the possibility of capital surprises through SREP add-ons. We focus on six typical concerns:

• The typical horizons for climate risk are not relevant to my institution. Climate risk analysis, despite its many facets, may not generate material findings for the bank’s portfolio, especially over the three to five-year ICAAP business planning horizon;
• It’s too early to be including climate risks in my ICAAP. The climate hazards have yet to be internally risk-mapped to the bank’s portfolio and, before this activity is completed, other practical aspects of climate risk management cannot be properly progressed within the 2021 ICAAP timeline;
• There is insufficient data for climate risk analysis and therefore, any ICAAP analysis is premature;
• Climate scenarios are too complex, posing selection, design and scenario generation challenges, falling outside current capabilities for scenario generation and stress testing infrastructure;
• Risk models that would underpin climate risk analysis are yet to be readied;
• Would better risk identification necessarily imply higher capital requirements? 

Each of the above concerns about climate risk inclusion in the ICAAP deserves fuller discussion.  We address each in more detail in our fuller write-up appended below, commenting on both the business imperative and the regulatory expectations.  There is of course, no single correct answer that holds for all institutions. Each bank would need to weigh up its own benefits against the efforts involved. But the pointers provided in our detailed note should help address concerns.  Click on the attachment below to learn more.

Our Financial Risk Management and ICAAP teams would be pleased to discuss any aspects of this with you further. Contact details are provided on the attached note.

[1] The ICAAP comments in this note are directly primarily at banks and building societies that are dual-regulated by the PRA and FCA and European firms subject to the ICAAP process. However, there are business reasons for IFPRU firms that run an ICAAP analysis to also give regard to climate risk.