Basel approach not sufficient to address climate-related risks

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.

What impact are the Principles likely to have?

Even though all the above elements are positive additions to the Principles, they do not fundamentally change the bigger view on what we can expect from their application. These expectations are largely shaped by the limitations of the high-level principle-based approach adopted by the BCBS, which hardly takes into account the specific features of climate-related financial risks when trying to fit them into the existing framework.

The missing piece of the approach taken by the BCBS is environmental materiality, the flip side of which is the systemic risk dimension of climate change. The fact that the Committee considers only financial materiality (i.e. financial risks from climate change for a bank) is a significant gap in capturing the interaction between climate change and the risks it poses to banks.

Financial materiality is, of course, essential and at the heart of the mission of the BCBS but when it comes to climate change, financial materiality is fed by environmental materiality. There is a doom loop by which financial institutions, and in particular banks, make climate change possible by providing financing to the companies and activities, which cause the bulk of greenhouse gas emissions. This environmental materiality translates into the systemic risk of climate change.

The lack of consideration of the double materiality approach by the BCBS not only hinders its ability to apprehend this vicious circle but, most importantly, it also hinders the possibility to develop macro-prudential policies to tackle it.

The lack of concrete measures or referenced best practices will likely limit the impact of the Principles in terms of managing climate-related financial risks. Given the lack of reliable statistical data, universally accepted risk metrics and measurement methodologies, decisions on all of these elements should not be left to banks at their own discretion.

The time dimension aspect stands out in this respect. The Principles rightfully recommend the consideration and management of climate-related financial risks over relevant time horizons. At first glance this would also suggest accounting for longer time horizons commensurate with the nature of climate change. However, if one considers that banks’ financial planning, risk management and compensation incentives frameworks are hardly able to take into account risks beyond one to three years, the notion of “relevant time horizons” appears to be hardly more than wishful thinking rather than something that can be translated into concrete action.

Under these circumstances, supervisors will hardly be able to reach comparable and credible conclusions with respect to the risk and capital position of banks, which is a precondition for imposing any additional supervisory capital requirements.

What’s next?

The Principles rightfully say that banks and supervisors will continue to develop their expertise and capabilities on climate-related financial risks. Yet, climate science tells us that the time we have to prevent major risks from materialising and disrupting the financial system is very limited. All eyes remain on the Basel Committee to come out with further measures based on their ongoing review.

Julia Symon