Reports outline banking system exposure to climate-related risks and recommend methodologies be adapted accordingly.
Banks and financial institutions need to expand and adjust their existing risk management frameworks to better account for climate-related financial risks, according to two reports published today by the Basel Committee on Banking Supervision (BCBS).
The findings emphasised that traditional risk categories used by financial institutions can be used to successfully identify climate-related financial risks, but methodologies need to be more granular and forward-looking to effectively measure and mitigate the extent of risk exposures.
The first report – ‘Climate-related Risk Drivers and their Transmission Channels’ – identifies the main climate-related financial risks faced by banks and financial institutions within six traditional risk categories.
The risk categories consist: Economic (losses due to increased severity of physical climate risk drivers); credit (climate risk reducing borrowers’ ability to repay and service debt); market (reducing financial asset values where climate risk isn’t incorporated into prices); liquidity (climate change reducing access to stable sources of funding); operational (regulatory compliance risks); and reputational (changing consumer sentiment towards climate change).
The report further identifies how physical and transitional risks are directly related to traditional financial risks.
For example, a physical risk of climate change may be the increased probability of wild fires in geographies such as California. This will have a direct impact on the livelihoods of people in that area and its microeconomy, translating into potential economic, credit and reputational risks for banks with customers and clients based in this area.
Transitional risks may be heightened by changes in governmental policy, such as commitments to net-zero carbon emissions. This could present some liquidity risks if accompanied by moves away from investment in or support of carbon-intensive industries, including by central banks or state-directed funds.
The second report – ‘Climate-related Financial Risks – Measurement Methodologies’ – provides an overview of the work that needs to be done for banks and financial institutions to measure and reliably estimate their exposure to climate-related financial risks.
This report highlights that bank assessments of climate risk are largely focused on near-term transition risk drivers, which doesn’t fully encapsulate the long-term risks climate change presents.
BCBS further analysed how (and if) banks and supervisors are constructing methodologies with climate risk in mind, identifying gaps in existing methodologies that need to be addressed.
“While a range of methodologies are currently in use or being developed, challenges remain in the estimation process, including data gaps and uncertainty associated with the long-term nature and unpredictability of climate change,” BCBS said.
The Basel Committee will continue work in this area with a three-pronged approach, focusing on regulatory, supervisory and disclosure-related challenges around climate risks within the banking system.
The Committee’s near-term objective will be to identify gaps in the current Basel Framework, which outlines BCBS’ full set of standards, where climate-related risks may not be sufficiently recognised by banks and financial institutions.