Finance Watch: Basel approach not sufficient to address climate-related risks
08 August 2022
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.
The publication of the “Principles for the effective management and supervision of climate-related financial risks”
by the Basel Committee on Banking Supervision (BCBS) on 15 June 2022
marks the completion of the first step of the Committee’s holistic
review of the Basel framework.
The work by the BCBS sets an important bar for how its members – 45
central banks and financial supervisors – will address climate-related
financial risks in the banking sector. So far this effort has drawn a
fair amount of public attention to the work and mandate of the Basel
Committee, but how likely are the Principles to have a meaningful
impact?
Disclaimer: This post was first published on Green Central Banking in June 2022.
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.
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