Climate and capital

Over recent years financial regulators have increasingly expected banks to integrate climate risk considerations throughout their organisations, including into their risk management frameworks.

Following the first round of climate stress tests, global regulators have turned their attention towards exploring how climate risks may be best captured within the prudential capital regime.

In an important step forward on this topic, the Bank of England convened academics, practitioners and policymakers to discuss views on a range of related issues including:

• The appropriate time horizons over which the range of climate risks should be reflected in capital requirements;
• How to deal with uncertainty over that time period, including the use of scenarios to more accurately measure and calibrate capital requirements more accurately; and
• Where these risks are best reflected in the capital regime, i.e. the appropriateness of microprudential firm-specific vs macroprudential system-wide capital requirements for climate risks.

In this short blog, we share some of our reflections on this topic based on our engagement with banking clients from across the industry. While views differ between institutions, four key messages are clear:

Improving stress testing capabilities will be the first step. Stress testing exercises are already employed to ensure that financial institutions are resilient to uncertain forward-looking risks and therefore these existing frameworks and methodologies could be repurposed to ensure resilience against climate-related risks. One key challenge for financial firms at this stage is that climate stress tests require a greater degree of counterparty, sector and geographic specificity than traditional macroeconomic stress tests. Most large banks have already begun to develop their climate scenario analysis capabilities and, as these approaches mature over the coming years, the stress testing component of Pillar 2b is likely to be the most appropriate element of the capital regime to account for climate-related risks.

It is still unclear to what extent climate risks are already captured by the existing capital regime. Climate change is a driver of traditional financial risks (such as credit risk, market risk, liquidity risk) and therefore there are several channels through which climate risks are likely to already be captured by the existing regime, including internal models, external credit ratings, the accounting regime and the Pillar 2 framework. The extent to which climate-related risks will be captured by these existing elements will depend on how physical and transition risks will evolve differently from traditional financial risks.

The approach to identifying and quantifying climate-related risks varies widely across financial institutions. Data availability, quality and standardisation remains a key challenge and initiatives to bridge these gaps are of high importance. Any gaps in the existing regime are likely to become clearer as firms’ abilities to accurately identify and measure climate risks improve. Any future changes to the capital rules will be dependent on the industry’s current efforts to rapidly develop and standardise quantitative approaches to modelling climate risk.

Any changes to the Pillar 1 rules should be agreed internationally by the Basel Committee on Banking Supervision (BCBS). In the longer-term changes to Pillar 1 Credit, Market and Operational Risk methodologies may be necessary, but at this stage there is uncertainty around which methodological approaches would be most appropriate. For example, suggestions to extend the time horizons embedded within capital rules may trigger a broader rethink of the purpose of the capital framework by potentially introducing other structural longer-term issues – such as aging populations. When standards are eventually agreed it is important that they are agreed at the international level by the BCBS, to support a level playing field and avoid further fragmentation in the implementation of capital rules.

At KPMG we are supporting Banking and Financial Services clients to face climate risk management challenges. If you’d like to understand more about how this topic could impact your business, or how we’re supporting clients to integrate climate risk into their existing capital and risk processes, please get in touch with us for further insights.

In particular, contact us if you’d like to know more about:

• ICAAP production and benchmarking – KPMG regularly provides banks with support on ICAAP production, reviews and benchmarking exercises, including on how best to incorporate climate risk.
• Economic capital and pricing frameworks – we can support clients to account for climate in their capital allocation and pricing processes by providing numerical approaches to modelling the macroeconomic (including scenario expansion) and financial impacts of climate change – leveraging our insights from our modelling experts and in-house climate risk modelling suite (Climate IQ).
• Embedding climate within risk processes – we can support the assessment and implementation of end-to-end climate risk management frameworks including governance, credit processes and IFRS 9 provisioning.