Climate-related financial risk in banking | The state of play on capital requirements

This blog was published on 23 July 2021.

At a glance:

• As the regulatory policy framework for climate risk develops, a key consideration for banks is how climate-related financial risks are captured by prudential capital requirements.
  
  
• Supervisors have made clear that banks are already required to integrate climate risk into their existing prudential risk management frameworks as a cross-cutting risk, and to consider climate as part of their ICAAP – as they would any material risk. But it is evident that until data, classification and modelling capabilities develop, banks’ ability to capture climate risks will be limited.
  
  
• Scenario analysis and stress testing will help with assessing banks’ climate risk exposure, and the BoE and ECB are running supervisory exercises in 2021 and 2022 respectively. In the near term those exercises will not be used to set banks’ capital requirements. However, supervisors will increasingly use the Pillar 2 framework to ensure that banks adequately manage their climate risk exposures, which will eventually lead to climate risk-related capital add-ons for at least some banks.
  
  
• These changes will in turn alter the capital cost of risk, and have implications for capital planning.
  
  
• Looking forward, the EBA and European Commission will assess by 2023 whether to include climate risk-specific requirements in the bank capital framework. This means that it is unlikely that the Commission’s proposal for the next iteration of EU legislation on capital requirement (CRD6/CRR3) will include any climate risk-specific capital requirements. For the UK, the BoE has said that there is currently too much uncertainty about the nature of the risk and how existing measures will help mitigate it to be able to take a judgement as to whether climate risk-specific prudential tools are required.
  
  
• Irrespective of the position taken on how climate risk should be managed for prudential purposes, policymakers may decide to apply the prudential framework to create additional incentives for banks to support the transition to a net zero carbon economy.  That said, the need for a scaling factor in order to accelerate the transition to net zero may have become less necessary since the introduction of the Green Asset Ratio (GAR) disclosure requirement for EU banks (under Article 8 of the EU Taxonomy).

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As the regulatory policy framework for climate risk develops, a key consideration for banks is how climate-related financial risks are captured by prudential capital requirements. COP26, which takes place in November, has more broadly also heightened banks’ focus on developing their climate action plans. This blog considers: the current state of play in the EU and UK; the potential introduction of climate risk-specific scalars within the capital framework; and the key implications for capital planning.

Climate risk is already captured by the prudential capital framework

From our conversations with banks, it is clear that there is significant industry interest in understanding whether the prudential capital framework might eventually include climate risk-specific RWA scaling factors i.e. “green supporting” or “brown penalising” factors. However, this debate should not distract from the fact that climate risk should already be considered as part of banks’ risk assessment, and therefore should already have an impact on bank RWAs and regulatory capital requirements.  In fact, this is likely to be the primary channel through which climate risk is reflected in capital requirements in future, and certainly in the near term (notwithstanding the presence of the infrastructure lending factor in CRR2, which already allows for a potential RWA discount for infrastructure lending exposures that meet certain ESG characteristics).

There is an emerging consensus among policymakers and supervisors that climate risk should be considered as a cross-cutting risk type – i.e. a driver of existing prudential risk categories (credit, market, liquidity, and operational risk). The ECB, in its Guide on climate-related and environmental risks, explicitly states that banks should consider climate risk (and environmental risk) in this way. The EBA’s recent report on management and supervision of ESG risks recommends that banks manage ESG risks (including climate) in the same way. At the international level, the NGFS and the BCBS came to the same conclusion. Although the PRA has to date taken a less prescriptive approach, the Climate Financial Risk Forum Guide on risk management describes the cross-cutting approach as good practice.

To achieve this, banks will need to embed climate risk in all parts of the risk management process – from setting risk appetite, through the point of origination of exposures, to the identification, measurement and monitoring of risks. This is a core part of the supervisory expectations that have been set for banks by the BoE and ECB. Integration into internal models will be a key task. Banks’ credit risk internal models, typically based on backward looking analyses of historical data, will need to be supplemented by tools that allow for a forward-looking perspective, such as scenario analysis. For standardised banks, risk weights and capital will also be influenced by the increasingly common integration of ESG factors into external agency credit ratings.

Modelling and data limitations may constrain banks’ near-term ability to measure climate risks. The PRA and ECB have made clear though that banks’ 2021 Internal Capital Adequacy Assessment Process (ICAAP) should already reflect climate risk, including commentary on the risk to capital.  And supervisors expect banks’ assessments to become more quantitative as data availability and methodologies improve. Over time, as banks fully embed climate risk into their risk management frameworks and assessment capabilities improve, the influence of climate risk on RWAs may increase (over and above any underlying change in the actual level of risk), raising the amount of capital held against climate risk exposures.

Supervisors will also use the Pillar 2 framework to ensure that banks hold sufficient capital against climate risk

The ECB has begun to incorporate climate risk into its Supervisory Review and Evaluation Process (SREP) methodology and expects the assessment of climate risk to become an integral part of the process in time. During 2021 the ECB is likely to only impose qualitative or quantitative requirements on banks on a case-by-case basis, but in future years will be prepared to impose quantitative requirements across the board. Our expectation is that this means that this year, it is likely only to take action where a bank is an outlier.

The EBA also recently published its final report on the integration of ESG risks into the SREP. Consistent with the approach set by the ECB, its proposal – which applies to all banks in the EU – is that as capabilities develop, supervisors should take a phased approach to consideration of ESG risks in the SREP. Supervisors would initially focus on how banks integrate climate risk into their strategies and governance, and how banks are advancing their climate risk measurement and management capabilities.  Once data availability improves, supervisors would more comprehensively and quantitatively analyse banks’ coverage of risks to capital and liquidity. The European Commission will formally empower national supervisors to incorporate ESG risks into the SREP in the forthcoming CRR3/CRD6 banking package.

Supervisory stress testing is also an important input into banks’ Pillar 2 Guidance. The BoE recently launched its Climate Biennial Exploratory Scenario (CBES), and the ECB plans to run a climate-focused supervisory stress test in 2022. Both the ECB and PRA have made clear that the results of the first round of climate risk stress tests will not have a mechanical link to banks’ capital requirements. Rather, supervisors will analyse the results of the exercises and give qualitative or possibly quantitative feedback to individual firms.

The ECB has indicated though that its 2022 supervisory stress test could have an indirect impact on banks’ Pillar 2 requirements through influence on banks’ SREP scores. It also highlighted that, as capabilities develop over the coming years, the results of climate risk stress testing will have a more mechanistic impact on banks’ Pillar 2 requirements and guidance than will be the case in 2022. 

Looking ahead: Policymakers are considering the use of climate risk-specific RWA scalars (green supporting/brown penalising factors) in the prudential framework

The EBA is due to publish a report by June 2023 on whether a dedicated prudential treatment for exposures based on their ESG characteristics would be justified.

With climate risk-specific scalars, banks could receive a risk weight discount for exposures that supported activities aligned to the transition to a lower-carbon economy (assessed, for example, on the basis of alignment to the EU’s taxonomy). Advocates believe that this approach would more explicitly incentivise banks to re-orientate their portfolios towards sustainable activities, given their relative capital efficiency. Alternatively, a penalising scalar could impose a risk weight penalty on exposures with poor sustainability characteristics.

For many advocates of scaling factors, the primary objective is to accelerate the transition to net zero. Bank supervisors are however constrained by their mandates to be concerned primarily about the safety and soundness of the banking sector, meaning that they are generally not in favour of amendments to the capital framework not directly linked to risk. In our view, the PRA’s greater influence on the policymaking process therefore means that the UK’s implementation of Basel 3.1 is unlikely to include a scaling factor, particularly given recent statements by Bank of England officials arguing that in their view it is too early to make a decision.

In the EU, the role of the European Parliament in the legislative process means that politicians will have a more direct influence on the content of the next EU banking package (CRD6/CRR3) – in principle, making it more likely that a scaling factor could be included. However, the timing of the EBA’s report means that it is unlikely that any specific prudential requirements for climate risks will be included in the Commission’s proposal for CRD6/CRR3 – although the European Parliament may table amendments to the proposal to introduce them at a later stage in the legislative process.

In any case, the need for a scaling factor in order to accelerate the transition to net zero may have become less necessary through the introduction of the GAR disclosure requirement for EU banks under Article 8 of the EU Taxonomy. The potential market reaction to banks reporting low GAR figures may provide sufficient incentive for banks to finance sustainable activities, even without any explicit capital incentive.

What are the implications for banks’ capital planning?

To support capital planning banks should consider embedding climate risk into two key areas:

• Business performance management: Senior management needs to decide which performance metrics to use to steer its decisions. This is an important step even whilst the capital regime is being finalised, as climate risks are already present on the balance sheet. Traditional financial return measures such as Return on RWAs may not be sufficiently forward-looking or climate risk sensitive. Some banks have started to incorporate climate risk into their funds transfer pricing mechanisms to help align incentive strategies for business lines, and to support the calculation of the economic value of portfolios under appropriate risk adjusted metrics. A simpler step could be to recalibrate internal expected return hurdle rates that govern lending or investment decisions.
  
  
• Financial resource management: Integrating climate risk into financial resource management offers a holistic approach to managing balance sheet adjustments as the economy transitions to “net zero”. One option is to take a top-down approach, adding climate risk metrics (or more broadly, ESG risk metrics) such as the GAR or carbon emissions intensity as factors in financial resource management frameworks, alongside capital, liquidity and general market constraints. Another option is to take a bottom-up approach by introducing Shadow Carbon Costing, i.e. an internal carbon price, as a means of accounting for future costs of climate change.

Conclusion

When considering the potential implications of climate change policy on their capital requirements, banks should not focus, in the near term, on the potential introduction of “green supporting” or “brown penalising” factors in the capital framework. Instead, banks should focus on integrating climate risk as a cross-cutting risk type into their risk management – gathering the necessary data from clients and building capabilities internally – and ensuring that their 2021 ICAAP includes commentary on climate-related risks to capital. And banks not demonstrating sufficient progress on climate risk management could face supervisory penalties.

This will, in turn, give banks a better understanding of the additional capital that they will need to hold against their climate risk exposure. In addition, banks should expect that additional capital requirements for climate risk are more likely to materialise in the medium-term through Pillar 2 – both through the SREP, and climate risk stress testing.  

COP26 provides an additional impetus for banks to progress their climate action agenda more broadly. These plans should incorporate and be consistent with banks’ expectations for the evolution of capital requirements and supervisory expectations