December 2022
The PRA's Model Risk Management (MRM) principles for banks are now live — see below for more on the requirements and how firms should be addressing them.
A comparison of findings
Prudential regulators focusing on the financial risks of climate change have had a busy year. In May, the UK’s Prudential Regulation Authority (PRA) released the results of its Climate Biennial Exploratory Scenario (CBES), followed in October by thematic feedback for banks and insurers on the expectations set out in Supervisory Statement 3/19, the 2020 Dear CEO letter and the 2021 Climate Adaptation Report. This feedback provides the first indication of how well banks and insurers are meeting regulatory expectations.
Similarly, having published its final Guide on Climate and Environmental (C&E) Risk in 2020, 2022 has seen the European Central Bank (ECB) ramping up its activity. In March it published a review of banks’ climate-related and environmental (C&E) disclosures, the results of a stress test on banks’ preparedness for managing climate risks in July, and in November it shared the results of its thematic review on the supervision of C&E risks.
Both regulators are now actively supervising climate-related financial risk and the two most recent sets of feedback represent a call to action for firms. While there are some similarities in the findings, with all institutions needing to do more, there are notable differences in approach when it comes to the overall regulatory view and remediation plans. Our ‘compare and contrast’ analysis below helps identify material divergences.
Scope
In terms of scope, the PRA’s feedback covers both banks and insurers, whilst the ECB’s findings are banking-specific. Although the European Insurance and Occupational Pensions Authority (EIOPA) has issued supervisory guidance for insurers and has assessed their exposure to physical risks, it has not yet released equivalent thematic findings to the ECB.
Additionally, the PRA’s review covers climate-related risk only. The ECB, on the other hand, also considers environmental risks, encompassing ‘water stress, biodiversity loss and resource scarcity’.
Key messages
The overarching message from the PRA is that banks and insurers have taken “concrete and positive steps” to implement supervisory expectations. It finds that governance of climate risks has advanced in most firms and that there is a general improvement in risk management practices. Firms have invested in improvements and, even where they still need to refine their approach, the actions taken have advanced their ability to address the risks and opportunities from climate change. However, the levels of embedding of overall practices vary and further progress is needed by all firms.
The ECB takes a more critical stance, noting that “banks are still far from adequately managing climate and environmental risks” and “continue to significantly underestimate the breadth and magnitude of such risks”. It notes that, although 85% of banks now have in place at least basic practices in most areas, they continue to lack more sophisticated methodologies and granular information on climate and environmental risks. It also expresses concern around the execution capabilities of most banks, with effective implementation of their practices still lagging.
The comparison below includes the most significant elements of the PRA and ECB reports. To note, the ECB has provided more quantitative data on how firms are performing in each area, whereas the PRA provides high-level commentary only.
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Institutional Architecture (overall approach and capabilities, mapping of responsibilities, mitigation strategy etc) |
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Risk Management |
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Data |
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Scenario Analysis |
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Governance |
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Disclosures |
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What next?
It appears that the PRA and ECB differ in their assessment of the extent to which firms are currently meeting supervisory expectations. Where the PRA recognises overall progress, though acknowledging the need to do more, the ECB is more critical.
What does this mean for banks and insurers operating in the UK and the EU? The PRA has been clear that every firm in scope of SS3/19 should by now be able to demonstrate how it is responding to supervisory expectations. It will continue to engage on this issue through BAU supervision and, where firms are not making sufficient progress, they will be asked to provide a roadmap to articulate how any gaps will be overcome. The PRA has also warned that supervisors will have recourse to the wider supervisory toolkit if firms do not adequately address climate risk.
For EU banks, the implications are more concrete. The ECB has sent feedback letters to individual banks. For significant institutions, these contained an average of 25 shortcomings, and more than 30 firms included in the review have been issued with binding requirements as part of the Supervisory Review and Evaluation Process (SREP) to address severe weaknesses. Full alignment with supervisory expectations is required by the end of 2024:
- By March 2023 - banks are expected to adequately categorise C&E risks and conduct a full assessment of their impact on activities
- By the end of 2023 at the latest - banks are expected to include C&E risks in their governance, strategy and risk management
- By the end of 2024 - banks must meet all the remaining supervisory expectations first set out in 2020 in the Guide on Climate-Related and Environmental Risks, including full integration into the ICAAP and stress testing
The ECB has made clear that it will monitor the deadlines and may use enforcement action to ensure compliance.
UK and EU firms should continue to monitor the PRA and ECB’s expectations as they evolve.