Understanding the Challenges and Opportunities
In November 2021, Basel Committee on Banking Supervision (BCBS) issued their consultative document on the principles for the effective management and supervision of climate-related financial risks, inviting feedback from interested stakeholders on the principles proposed.
Taking a principles-based approach to improving risk management and supervisory practices related to climate-related financial risks, BCBS has composed 18 high-level principles split between providing guidance on managing climate-related risks to banks (principles 1 -12), and prudential supervisors (principles 13 through 18). The principles have been constructed to provide a common baseline for internationally active banks and supervisors, covering a wide range of banking systems and should be applied according to size, complexity, and risk profile.
BCBS acknowledge that whilst the scenario analysis and stress-testing guidance is aimed at larger international banks and supervisors within BCBS jurisdictions, smaller organisations in all jurisdictions would also benefit from taking a similar approach.
According to the BCBS, banks are potentially exposed to climate-related financial risks regardless of size, complexity, or business model. Consequently, consideration needs to be given to the potential impact of such risks on business models from the already evident physical and transition risks to those that may emerge over time. The BCBS expectation is that banks continuously develop capabilities and expertise in this area proportionate to the risks faced across functions.
Climate change is illustrating new sources of volatility across a bank’s portfolio. This is driving regulators and investors to seek clarity from banks with respect to their exposure to physical and transition risk which includes litigation and reputation risk. Importantly, banks should also be considering how the address and take advantage of the opportunities in the new climate resilient economy.
The availability of high quality, credible and validated risk modelling for these exposures varies by peril, type of asset, and geography. Developing a deep asset-by-asset basis understanding of the climate risk embedded on balance sheet and working towards effective risk mitigation and risk transfer strategies, should be a core focus.
The Need for Innovative Tools
Traditional risk quantification methodologies are unable to predict how climate change will affect business models in the future. Scenario analysis presents a more accurate tool to assess the impact, identify strategic priorities, and meet the requirements of regulators and other stakeholders who are now paying more attention to how climate change is creating financial risk. This approach has the added advantage of creating opportunities for organisations to access capital as well as developing asset vulnerability studies that can further validate risks and identify opportunities. Further advantages include:
- Scenario analysis that quantifies the impact of climate change and climate transition on business models, financial performance, and operational resiliency
- Risk transfer programmes with tailored wording created to manage the impact of specific events - with a loss being paid on an agreed value when a pre-defined event is triggered
- Partnering with a climate service enables the identification of the perils likely to have the most impact on a bank’s business model through the Climanomics®1 platform, and the related timeframe
To discuss any of the topics discussed in this article, please contact Derrick Oracki
or Joel Sulkes
or Daniel Butler
Head of Financial Institutions Risk Consulting
Global Financial Institutions Industry Leader
EMEA Head of Financial Institutions Industry Vertical and Risk Advisory