What do the evolving prudential regulations on climate change risks mean for banks?
As climate-related financial risks continue to receive increasing regulatory attention, regulatory authorities are set to increase the rigour of banks’ public disclosure, capital planning and governance processes to ensure they manage their relevant exposures in a prudent manner. While prudential regulations on climate change risks become more stringent, banks choosing to adopt a reactive approach to the relevant domestic and the international regulatory developments may find it more challenging to address their shortcomings amidst other concurrent regulatory challenges.
At the EU level, the European Banking Authority’s (EBA) expects firms to actively identify and manage their climate-related risks. As outlined in its Action Plan on Sustainable Finance of 6 December 2019, it plans to focus initially on strategy and risk management and associated key metrics and disclosure. It then plans to focus on developing a dedicated climate change stress test and to look into the evidence around the prudential treatment of ‘green’ exposures. At the UK level, on the other hand, the Prudential Regulation Authority (PRA) has started introducing its own regulatory expectations.
The EBA plans to publish a number of discussion papers, technical standards and further guidance across its environmental, social and governance (ESG) mandates from 2020 to 2025. But for now, its Action Plan provides clarification on its policy direction and expectations from firms on areas where action is needed now to support the move towards more sustainable finance in the EU. The plan sets out a sequenced approach which consists of key metrics, risk management, scenario analysis and adjustments to risk weights, respectively. The EBA expects and encourages banks to act on climate-related risks now rather than waiting for rules to be finalised.
In the UK, the PRA has already provided clarification on its regulatory expectations by publishing a policy statement and supervisory statement in April 2019, introducing a number of strategic, operational and regulatory challenges for banks. First and foremost, it expects banks to define clear responsibilities and accountabilities within their internal governance frameworks, ensuring that climate change-related financial risks have clear ownership throughout the organisation. In practice, this will require them to allocate responsibility for identifying and managing climate change risks to an existing Senior Management Function, and ensure board-level involvement and challenge in their Internal Capital Adequacy Assessment Processes (ICAAP).
The PRA expects banks to assess the impact of the financial risks from climate change on their overall risk profile and business strategy. More specifically, it requires banks to include any material climate-related financial risks and exposures in their ICAAPs, taking into account quantitative and qualitative metrics to monitor their exposure to climate change risks.
The PRA has already provided high-level guidelines on how to conduct scenario analyses and how to use these to assess the impact of financial risks arising from climate change. So, banks should start considering how they can incorporate climate-related factors in their risk modelling frameworks. While the PRA is not very prescriptive at this stage on how banks should meet these expectations, it broadly expects banks to adopt scenario analysis and stress testing within their ICAAPs to ensure their climate change related exposures are covered by a commensurate amount of capital.
Given the ICAAP should be proportionate to the nature, scale and complexity of the business, banks should monitor climate change risks on an ongoing basis to identify and assess potential threats in a timely manner, taking preventive action to ensure that their capital sources remain adequate to mitigate relevant risks. At the very least, banks should assess the climate change risks in their investment and loan portfolios, outsourcing arrangements and supply chains.
The PRA expects banks to devise their own scenarios to understand the impact of financial risks arising from climate change on their solvency and liquidity. This means that banks should use both long and short-term scenario analyses to inform strategic planning and decision-making. Banks offering commercial mortgages, or loans to industries or sectors which are sensitive to climate change such as the agricultural sector, should take into account their exposures to acute physical risks such as heatwaves, floods, wildfires and storms. Similarly, some residential mortgages books might be impacted by flood risk, which would affect the credit risk on loan books through greater loss given default and the probability of default.
Stress scenarios should also include longer term changes such as rising temperatures, weather variability and sea level rise, which may impair asset values, increase credit risks and reduce the value of investments held by banks. In particular, banks should consider the potential impact of sea level rise on coastal properties over time. They should of course also take into account any potential operational risks from extreme weather events, capturing any risks to their business continuity in their ICAAPs, being particularly mindful of how outsourced functions might be exposed.
The PRA also requires banks to be able to identify, measure, monitor, manage, and report on their financial risks arising from climate change through their existing risk management framework, in line with their risk appetite. This means that they should integrate climate change-related financial risks into their governance and risk management processes, evidencing this in their risk management policies, management information and board risk reports.
Banks with exposures to clients in energy and transportation sectors where the transition to a lower-carbon economy may have a substantial impact on business models should also take into account the risk of reduced earnings and business disruption. In addition, institutions with substantial trading books should also take into account the impact on commodity prices, derivatives contracts, corporate bonds and equities.
Interpreting some of the PRA’s requirements remains challenging. For instance, the onus is on banks to decide if risks are material and to articulate how they have determined what constitutes a material exposure in the context of their business. Similarly, it is their responsibility to assess if they should disclose additional information on their climate change-related financial risks. So banks should start considering how to identify material climate change exposures and enhance their Pillar III frameworks to disclose more information on them, taking into account the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures.
On 18 December 2019, the Bank of England (BoE) clarified its proposed approach to stress testing with respect to climate change risks through a discussion paper. It proposes to use stress testing to assess the resilience of the business models of the largest banks, insurers and the financial system to financial risks posed by climate change under the 2021 biennial exploratory scenario. At this stage tests are intended to only to identify and address any data gaps rather than determining firms’ capital requirements. But it requires firms in scope to start preparing to incorporate climate-related risk factors in their risk modelling frameworks.
In conclusion, banks should start adopting climate considerations into their governance structures, business strategies and risk management frameworks; identifying metrics that provide transparency on the impact of climate-related risks on their business and adopting climate scenarios to understand their exposure to climate-related risks, including both physical and transition risks. Planning ahead will make compliance with regulatory expectations less painful. So banks would be well advised to start tackling these emerging challenges head-on now by adopting a proactive approach.
Mete Feridun is a Manager in the Financial Services Risk and Regulation division of PwC United Kingdom. The views and opinions expressed in this blog are those of the author and do not necessarily reflect the official views and opinions of PwC.
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