08 August 2022

Finance Watch: Basel approach not sufficient to address climate-related risks

This approach largely ignores the fact that climate-related financial risks differ from “traditional” types of risk in that they grow with time of inaction and lead to non-linear and irreversible changes that will affect the economy and financial system.

How novel are the Principles?

The Principles are the first formal guidance on climate-related financial risks from the global standard-setter and a clear attempt towards consistent supervisory expectations and practices. Yet, they do not introduce any novel instruments or tools whilst seeking to adapt two (out of 14) blocks of the existing Basel principles and standards to climate-related financial risks: the Core principles for effective banking supervision (BCPs) and the supervisory review process (SRP).

This approach largely ignores the fact that climate-related financial risks differ from “traditional” types of risk in that they grow with time of inaction and lead to non-linear and irreversible changes that will affect the economy and financial system.

As climate-related risks materialise via traditional risk categories, it appears appropriate to advise the integration of climate-related financial risks into all existing components of institutions’ risk management and supervision – business models and strategies, governance, processes for risk identification, assessment and measurement, management, monitoring, capital and liquidity assessment and eventually reporting. While this might sound comprehensive, the actual guidance is quite generic and does not address the existing challenges of dealing with climate-related financial risks. This raises concerns about the feasibility, practicality and expected impacts of the Principles in practice.

What is notable about the finalised Principles compared to the draft for consultation?

Caught between civil society calls for more ambitious and precautionary actions, and industry pleas for a gradual approach and against any capital measures, the Basel Committee went for some limited additions and clarifications in the final version of the Principles:

• The board and senior management were named as responsible to ensure “that their internal strategies and risk appetite statements are consistent with any publicly communicated climate-related strategies and commitments”. Thereby the numerous publicly communicated net-zero commitments of banks could be brought into the regulated space and supervisors could verify their credibility.
• Banks should review compensation of their management to make sure it aligns with climate-related risk management objectives.
• The distinction between climate stress tests and scenario analyses was clarified, which has important implications from the risk management perspective: Whilst stress tests should reach conclusions with regards to an institution’s financial position and thus, potentially imply capital measures, scenario analyses are merely exploratory exercises. However, the likelihood of financial implications and conclusions in terms of capital of stress tests in the near future can be put into question given the current level of maturity of these exercises.
• Banks should consider climate-related financial risks in their ongoing monitoring and engagement with clients – a subtle, yet noticeable, nuance which draws attention to the aspect of engagement with clients. Indeed, engagement can be a tool for banks to manage risk via incentivising positive behavioural changes of their clients towards a low-carbon transition.

more at Finance Watch

© Finance Watch