The Basel Committee on Banking Supervision (BCBS) published two reports on 14 April 2021 as part of their fundamental research initiative on climate-related financial risks for banks. It may read as yet another stocktake – this time on transmission channels of climate-related risks to the banking system and measurement methodologies. It is however part of a larger endeavor. Their approach resembles to what we have seen among European regulators and supervisors yet it seems to miss the momentum we see in Europe.
The BCBS's Taskforce on Climate-related Financial Risks (TFCR), responsible for the reports, is following a sequential approach to understand this emerging risk and subsequently determine a view on if and how it should be incorporated in the Basel Framework.
The bigger picture
In February 2020, the Basel Committee established the TFCR to undertake work on climate-related financial risks. Its first action completed in April 2020 was an overview of existing regulatory and supervisory initiatives on climate-related risks. Several member jurisdictions – including the EU – already acknowledged that climate-related risks could potentially imply material risks for financial stability and justified actions to understand the risks better. As such, they initiated actions to incorporate climate-related risks explicitly in banks' risk management frameworks.
With this publication the second action is completed and it marks the beginning of investigations into the extent to which climate-related financial risks should and can be addressed within the existing Basel Framework covering regulatory, supervisory and disclosure-related elements.
Transmission channels: the focus is on credit risk
Transmission channels are the causal chains that explain how climate risk drivers impact banks directly and indirectly through their counterparties, assets, and the economy in which they operate. Banks and the banking system are exposed to climate change through transmission channels that arise from two distinct types of climate risk drivers, i.e. physical and transition risk. The TFCR analysis confirms that the effects of climate risk drivers on banks' financial risks are complex and highlights that existing research exhibits a range of approaches for how they should be studied. Click here for a summary of their analysis.
Figure 1 Financial risks arising from climate-related risk factors (based on the BCBS 2021 publication)
Unsurprisingly existing research has taken a somewhat risk-based approach as the focus so far has been on how specific climate risk drivers can impact narrowly defined – typically carbon-intensive – sectors of particular economies, individual markets and/or a top-down assessment of the macro economy. Besides hypotheses on what would be high risk drivers, another reason for this focus by existing research is the availability of relevant data to quantitatively assess hypotheses on possible transmission channels. Such data relates among others to vulnerability of corporates, households and properties to climate risk and information to connect climate risk drivers to traditional credit risk indicators such as corporate profitability, collateral values, PDs, LGDs, etc. Hence, various initiatives around disclosures are imperative to unlock such data.
Measuring climate-related financial risks is an iterative process
Their second report concerns measurement methods. Climate-related financial risks challenge traditional measurement methods:
- Limited ability to use history as a guide for future developments.
- High data granularity compared to for instance traditional credit risk analysis is needed to assess both physical risks (geolocational data given spatially varying characteristics of climate impacts) and transition risks (counterparty- and industry level data).
- The traditional methods focus on capturing near-term risks (typically up to three to five years). Minimum capital requirements have even been designed to capture only unexpected losses over a one year horizon.
The TFCR gives an analysis of the efforts so far in developing measurement methodologies and efforts to address above challenges. Click here for a summary. An understanding of the transmission channels is essential to develop proper measurement methodologies and indeed is a cornerstone in their conceptual framework to assess climate-related risks.
To date, measurement of climate related financial risks has a spotlight on mapping near-term transition risk drivers into bank exposures. Credit risk measurement has attracted the most effort, with a lesser focus on other risk categories. Initial scenario analyses and stress tests have in many cases focused on selected portfolios or exposures for transition risks, and selected hazards for physical risks. The TFCR concludes that key areas for further analysis relate to gaps in data and risk classification, as well as methodologies to address uncertainties associated with the nature of climate change and the potentially longer time horizon for risks to manifest.
We do see increasingly initiatives to bring the analysis of physical and transition risks together in a consistent and coherent way and move beyond the traditional practice among climate researchers to assess these risk types separately.