Principles for the Effective Management and Supervision of Climate-related Financial Risks

After completing this reading, you should be able to:

• Describe the principles for the management of climate-related financial risks related to corporate governance and internal control framework.
• Describe the principles for the management of climate-related financial risks related to capital and liquidity adequacy and risk management process.
• Describe the principles for the management of climate-related financial risks related to management monitoring and reporting, comprehensive management of credit risk and other risks, and scenario analysis.
• Describe the principles for the supervision of climate-related financial risks related to prudential regulatory and supervisory requirements for banks and the responsibilities, powers, and functions of supervisors.

Financial risks associated with climate change can affect banks regardless of their size. Therefore, banks should think about how climate-related risks affect their operations and evaluate how financially significant these risks are. They must manage the financial risks associated with climate change in a way that is appropriate for the scope and complexity of their operations and the level of risk that each bank is willing to take.

Risks associated with the climate can have extensive effects. The distinct characteristics of these risks, such as potential transmission channels, the intricacy of the impact on the economy and financial sector, and uncertainty related to climate change, should be considered.

The effects of climate change might manifest throughout a wide range of time and are expected to get worse with time. A bank’s typical two- to three-year capital planning horizon may not be long enough to account for all climate-related risks. Given how unpredictable the timing of these risks is, banks should approach building their risk management capabilities with caution and flexibility.

Banks should continually expand their knowledge and skills about financial risks associated with climate change in line with the risks they confront. Further, banks should make sure they have the resources set aside to manage these risks.

There is no recommended board structure in the Basel framework principles.

Corporate Governance

Principle 1: Banks should create and implement a robust approach for comprehending and evaluating the potential effects of climate-related risk drivers. Banks should consider significant financial risks associated with climate change that could arise across a range of time frames and incorporate these risks into their overall business plans.

When creating and implementing their business plans, banks should take material physical and transition risk factors into account. This includes understanding and assessing how these risks may affect how resilient a bank’s business model is over the short, medium, and long terms. The board and senior management ought to be involved in pertinent phases of the procedure. Besides, the managers and staff at the bank ought to be made aware of the board’s strategy.

A bank’s strategy and risk management frameworks should consider the serious financial risks associated with climate change. Besides, the board and senior management should decide whether changing remuneration practices is necessary.

Banks’ risk management plans should be in line with their declared goals and objectives. The board and senior management should make sure that their internal strategy and risk appetite declarations are in line with any disclosed climate-related strategies and commitments.

Principle 2: In addition to exercising effective oversight over financial risks associated with climate change, the board and senior management should clearly define members’ and committees’ roles in managing climate-related risks.

Board members or committees should specifically be charged with managing climate-related financial risks. This responsibility should be adequately considered as part of a bank’s business strategy.

Banks need to make sure that the board and senior management are aware of the financial risks associated with climate change and have the knowledge and experience necessary to handle those risks.

Banks should clearly define and assign duties and responsibilities related to recognizing and managing climate-related financial risks in their organizational structure and make sure relevant business units have enough resources to carry out these obligations.

Principle 3: Banks should develop the proper policies and procedures and implement them across the entire organization to achieve successful management of climate-related financial risks.

All relevant activities and business units should implement policies, methods, and controls that include management of major climate-related financial risks.

Internal Control Framework

Principle 4: Banks should include climate-related financial risks in their internal control procedures to ensure solid, thorough, and efficient identification, measurement, and mitigation of material climate-related financial risks.

A clear description and assignment of climate-related responsibilities and reporting should be part of the internal control structure.

Climate-related risk assessments may be carried out throughout client onboarding, credit application, and credit review stages. In addition, these assessments should run during ongoing client interaction and monitoring as well as in new products or business approval processes.

Independent of climate-related risk assessments, the risk function should be in charge of conducting climate-related risk assessments and monitoring. This involves questioning the initial evaluation made and ensuring that all applicable laws and regulations are followed.

The quality of underlying data, the risk governance framework, the business and risk profile, and the overall internal control structures and systems should all be independently reviewed and objectively assured by the internal audit function.

Capital and Liquidity Adequacy

Principle 5: Banks should identify and quantify climate-related financial risks and incorporate those determined to be material over relevant time frames into their internal capital and liquidity adequacy assessment processes.

Banks should develop procedures to assess how climate-related financial risks that could materialize within their capital planning horizons will affect their solvency.

It is equally important for banks to determine if climate-related financial risks could result in net cash outflows or the depletion of liquidity buffers. Banks can do this by considering extreme yet possible scenarios and including those risks in their internal liquidity management strategies.

The incorporation of climate-related financial risks that have been deemed material also entails the incorporation of physical and transition risks that are pertinent to a bank’s business model, exposure profile, and business strategy. These ought to be evaluated for inclusion in their stress testing programs as data over appropriate time horizons.

As the methodology and data used to analyze climate-related financial risks continue to develop over time and analytical gaps are closed, it is believed that these risks will likely be continuously incorporated into banks’ internal capital and liquidity adequacy evaluations.

Risk Management Process

Principle 6: Banks should recognize, track, and manage all financial risks related to the climate that could significantly deteriorate their financial position and capital resources while making sure their risk management strategies consider all potential risks and establish a solid plan for dealing with them.

The board and senior management should make sure that a bank’s risk appetite structure clearly defines and addresses climate-related financial risks, where applicable.

To begin with, banks should routinely conduct thorough assessments of the financial risks associated with climate change. They should establish such risks’ definitions and thresholds for materiality, including the risks posed by concentrations in particular sectors and geographical areas. Banks need to identify important risk indicators that are appropriate for their regular monitoring and escalation procedures.

Further, banks should think about risk-reduction strategies. Among others, such strategies could include setting internal caps for the many kinds of significant financial risks related to climate change to which banks are exposed.

Lastly, banks should keep an eye on future developments. They should work to understand and manage the impacts of climate-related risk drivers on other material risks because there may yet be undiscovered channels for transmitting these risks to traditional financial risk categories.

Management Monitoring and Reporting

Principle 7: For efficient board and senior management decision-making, banks should work to ensure that their internal reporting systems are capable of monitoring significant financial risks related to the climate and delivering timely information.

To make it easier to identify and report risk exposures, concentrations, and developing concerns, a bank’s risk data aggregation capabilities should incorporate climate-related financial risks. It should have mechanisms in place to guarantee the accuracy and reliability of the gathered data. In addition, a bank should have systems in place to gather and aggregate financial risk data connected to climate across the entire company.

In order to better understand their transition strategies and risk profiles, banks should think about actively engaging customers and counterparties and gathering more information. In the absence of trustworthy or comparable information, banks may consider adopting reasonable substitutes and assumptions.

Considering the dynamic nature of financial risks associated with climate change, banks should determine an acceptable frequency for updating internal risk reporting.

To assess, track, and report financial risks associated with climate change, banks should establish qualitative and quantitative measures and indicators. Any restrictions that impede this should be made clear to the relevant stakeholders.

Comprehensive Management of Credit Risk

Principle 8: Banks should be aware of how climate-related risk factors affect their credit risk profiles and make sure that their credit risk management systems and procedures take these risks into account.

Banks should have carefully thought-out credit policies and procedures to address significant climate-related credit risks. These include appropriate policies and procedures to recognize, quantify, assess, track, report, and manage or lessen the effects of significant climate-related risk drivers.

Banks should take a variety of risk-mitigation measures into account to control significant climate-related credit risks. Such measures include altering credit underwriting standards, using targeted customer interaction, or putting restrictions on loans.  Additionally, they need to put restrictions on the businesses, industries, or geographic regions that they are exposed to that do not fit their risk tolerance.

Comprehensive Management of Market, Liquidity, Operational, and Other Risks

Principle 9: Banks need to be aware of how climate-related risk factors affect their market risk positions and make sure that market risk management systems and procedures take important climate-related financial risks into account.

Banks should determine the risk factors related to climate change that are most likely to have an impact on the value of the financial instruments in their portfolios. Besides, they should assess the likelihood that losses will occur and the potential for increased volatility and set up efficient procedures to limit or mitigate the resulting effects.

An analysis of a sudden shock scenario could be a helpful tool for better understanding and evaluating the relevance of climate-related financial risks to a bank’s trading book. Among other factors, such evaluation focuses on variation in liquidity across assets exposed to climate-related risk and the speed at which exposures could reasonably be closed out.

Banks may consider how the cost and accessibility of hedges could change when assessing their mark-to-market exposure to climate-related risks.

Principle 10: The influence of climate-related risk drivers on banks’ liquidity risk profiles should be understood, and banks should make sure that their systems and procedures for managing liquidity risk consider significant financial risks associated with climate change.

Banks should evaluate the effects of financial risks related to climate change on net cash outflows or the value of the assets that make up their liquidity buffers. Banks should take these effects into account when calibrating their liquidity buffers and when developing their frameworks for managing liquidity risk.

Principle 11: Banks need to be aware of how climate-related risk factors affect their operational risk and take the necessary steps to account for these risks if they are significant. This comprises risk factors relating to the climate that could increase the risk of strategic, reputational, and regulatory compliance.

When creating business continuity plans, banks should consider the material climate-related risks that could have a significant impact on their operations and their capacity to continue delivering essential services.

Banks should evaluate how climate-related risk drivers affect other risks, such as strategic, reputational, regulatory compliance, and liability risks. Banks should take such risks into consideration as part of their risk management and strategy-setting operations.

Scenario Analysis

Principle 12: Banks should utilize scenario analysis to evaluate the adaptability of their business models and strategies to a variety of scenarios and assess their impact on the company’s overall risk profile. A variety of significant time horizons should be considered when evaluating these.

The goal of climate scenario analysis should be in line with a bank’s overall goals for managing climate risk. The scenario analysis may include examining how the bank’s strategy and the shift to a low-carbon economy will be affected, as well as measuring the bank’s vulnerability to these risks and calculating exposures and potential losses.

Scenario analysis should consider relevant climate-related financial risks. Besides, it should encompass a variety of conceivable outcomes. Banks should also think about the advantages and drawbacks of various scenarios and assumptions.

Banks should develop the capacity and knowledge necessary to carry out climate scenario analyses that are proportional to their size, complexity, and business model. Consequently, larger, more complicated banks should have stronger analytical capabilities.

Scenario analysis should use a variety of time horizons, from short- to long-term. Risk analysis can be conducted over shorter time periods with less uncertainty, while longer time frames will have higher levels of uncertainty.

Climate scenario analysis is a very dynamic field, and the methods employed are expected to change quickly. Models and findings from climate scenario analysis should be challenged and reviewed frequently by a variety of internal or external specialists.

Practice Question

Considering the Basel Committee’s recommendations on climate-related financial risks, a globally operating bank is enhancing its risk assessment framework. One aspect of this enhancement is the integration of climate-related financial risks into its existing credit risk assessment model. Which of the following approaches aligns best with the Basel Committee’s principles for effectively incorporating these risks?

A. Relying on static risk models based solely on historical financial data of borrowers.
B. Using dynamic risk models that incorporate only qualitative assessments of borrowers’ environmental policies.
C. Employing an enhanced credit risk model that integrates scenario analysis for assessing borrowers’ exposure to both physical and transition risks.
D. Limiting the assessment to direct financial impacts of climate-related risks without considering the broader systemic implications.

The correct answer is C.

Employing an enhanced credit risk model that integrates scenario analysis for assessing borrowers’ exposure to both physical and transition risks is the most effective approach. This aligns with the Basel Committee’s emphasis on dynamic, forward-looking risk assessments that consider the multifaceted nature of climate-related risks. It allows the bank to evaluate the potential impact of climate change on borrowers’ creditworthiness under various scenarios.

A is incorrect because static risk models based solely on historical data do not account for the dynamic and prospective nature of climate-related financial risks.

B is incorrect as relying only on qualitative assessments does not provide a comprehensive view of the potential financial impacts of climate risks.

D is incorrect because focusing only on direct impacts ignores broader systemic implications and potential indirect effects of climate risks.