A detailed look at ongoing prudential initiatives under Pillar II shows that they are needed, but reveals their intrinsic limitations and suggests the need for stronger prudential measures.
N.B.: This text features extracts from the Finance Watch report “A silver bullet against green swans”
Leading regulators, supervisors and researchers from around the world
have long recognised the financial stability implications of climate
change and the financial nature of climate-related risks. Financial
stability is at risk, as climate change-related extreme events will
disrupt our ecosystems, infrastructures, supply chains, impact human
health and mortality. These events will, in turn, lead to massive and
abrupt devaluations of assets and collateral held by financial
institutions, unexpected price swings and market movements affecting the
whole spectrum of financial risks across our financial system.
- [+] Green Swans – A closer look at climate-related financial risks (CRFR)
Climate-related financial risks have specific
features, which pose significant challenges when it comes to deploying
existing prudential tools and approaches to tackle them. Specifically:
Disruption risk: Climate-related events are defined
as “green swans” and have specific features, which makes them impossible
to predict and model. In particular, green swans are characterised by:
i) certainty of their occurrence despite highly uncertain impacts and
the impossibility to determine the exact timing of their
materialisation; ii) wide-ranging and existential impacts on the economy
and the financial system; iii) a high degree of complexity, including
cascade effects and chain reactions in the environment, economy and
society.
Probabilities of climate-related events not reflected in past data:
Traditional risk modelling based on historical data is not possible as
we are dealing with a forward-looking phenomenon, for which no past data
can be used reliably to extrapolate the future. By definition, when the
data eventually arrives, it will be too late to avert a global climate
change-induced financial crisis.
Growing risk with prolonged inaction: The magnitude
and probability of climate change materialisation are increasing as long
as no tangible actions are taken to reduce greenhouse gas emissions.
Once global temperatures have exceeded their pre-industrial level by
2°C, the consequences on human society and the global economy will be
irreversible and largely unpredictable.
The time horizon of climate-related financial risks materialisation
can be significantly longer than the horizon of the current business
forecasting, planning and risk management frameworks. This poses
additional challenges for financial institutions to appropriately
incorporate CRFR into their management practices.
Environmental stability, including climate, is by nature a public
good, which comes at no cost to private agents. Coupled with the long
materialisation horizons of climate-related financial risks, this means
that businesses and financial institutions do not have incentives to
consider the implications of their activities for the
environment/climate. Looking after public good is the mission of
governments/regulators, not private agents.
The role of prudential policy is to ensure that climate-related
financial risks are identified and appropriately managed by financial
institutions. In this respect, views on the most appropriate prudential
measures are widely divergent. Different prudential solutions exist to
incorporate CRFR into the existing prudential frameworks and in
particular into risk management processes. Pillar II measures have been
the focus of this debate lately and this article looks into their role.
Breakdown of possible Pillar II measures to manage CRFR
Under Pillar II, banks and insurance companies are obliged to
establish risk management processes and assess the adequacy of their
capital to cover all the risks they can potentially face in the course
of their business, which includes solvency. Supervisory authorities then
conduct their review and assess institutions’ risk profiles from four
different angles: (i) business model, (ii) governance and risk
management, (iii) capital and (iv) liquidity. Based on this assessment,
institutions are required to maintain additional capital (Pillar II
add-on) for risks that are not covered by minimum regulatory capital
requirements under Pillar I.
1 Financial institutions’ risk management and capital assessment processes
Advocates of Pillar II prudential measures as a tool to address CRFR
argue that financial institutions are best placed to assess and manage
their risks, including CRFR. According to them, this can be achieved
specifically via[1]:
- Assessing CRFR at exposure/borrower level when taking financing decisions.
- Considering CRFR in the internal risk and capital/solvency assessment process.
- Aligning the institution’s portfolio with the Paris Agreement, such as 2050 net-zero emissions (net-zero alignment).
Whilst Pillar II measures are an important element of the
institutions´ own risk management process, significant challenges need
to be resolved before these measures can lead to effective and impactful
outcomes in managing CRFR, which means that the measures are unlikely
to come in time to prevent major CRFR from materialising...
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