Meeting expectations on climate-related financial risk

December 2023

"Supervisors noted that banks lacked the capacity to fully implement the Principles in the first 12 months.” This was one of the key observations in the Basel Committee for Banking Supervision's (BCBS) newsletter on the progress of banks and supervisors in implementing its Principles for the Effective Management and Supervision of Climate-Related Financial Risks. 

While the newsletter acknowledges that several of the principles have at least been partially implemented, the key message from the BCBS is that further work is still required. This is a message to which banks are becoming accustomed. Over the last twelve months, the Bank of England (BoE), PRA, ECB and EBA have also provided feedback or recommendations on how banks can strengthen their management of climate-related financial risks — and the ECB has started to issue penalties where firms have failed to meet supervisory timelines. 

So where should banks be focusing their activities and how can they ensure that they meet supervisory expectations?

The BCBS principles were published in June 2022. The newsletter found that:

• Banks' progress was lagging on the quantification of climate-related financial risks, data collection and adequate measurement through reliable risk metrics and key risk indicators. 
• Implementation of Principle 5 on capital and liquidity adequacy was generally found to be at an early stage — noting that climate-related risks will likely be integrated into relevant assessments “iteratively and progressively”. Most supervisors found that there had been no progress on incorporating climate-related capital and liquidity impacts into existing assessment processes.
• Data availability and quality make full implementation across all the principles more challenging.

The BCBS identifies three key area of focus for banks to support further implementation of the principles:

• Enhancing data availability and quality — the BCBS notes that “banks will need to invest in better tools and greater automation to capture climate data” and continue with their efforts to gather data via targeted questionnaires, client due diligence and assessment of public disclosures. While methodologies and data to analyse climate-related financial risks evolve, the BCBS encourages banks to consider using reasonable proxies and assumptions.
• Building capabilities — supervisors have noted that banks often lack the necessary experience and expertise to implement the principles fully. The BCBS encourages them to continue to strengthen their capabilities, noting that expertise should be drawn from multiple risk areas given the multidisciplinary approach required to manage climate-related risks. 
• Applying climate scenario analysis — the BCBS notes the importance of collaboration between supervisors and banks on climate scenario analysis. However, banks must perform their own internal scenario analysis work and not rely solely on supervisory exercises.

The messaging from the BCBS is consistent with what industry has heard from EU and UK supervisors and policymakers. As the BCBS notes, "the majority of member jurisdictions have taken steps to implement the Principles in domestic supervisory frameworks and practices through the issuance of draft or final guidance, or have plans to issue such guidance”.

In October 2022, the PRA issued thematic feedback for banks and insurers on meeting the expectations of SS3/19. It found that in many cases climate risk considerations still needed to be embedded fully into risk management frameworks. Firms needed to make progress on expectations around risk management frameworks (e.g. developing Risk Appetite Statements that included quantitative metrics for climate risk), capital (e.g. modelling approaches, model types, underlying assumptions etc), and decision-useful scenario analysis that linked to business strategy. Shortly afterwards, the ECB published the results (PDF 1 MB) of its thematic review on the supervision of climate-related and environmental risk. Its key message was that banks were “far from adequately managing climate and environmental risks” and that they significantly underestimated the breadth and magnitude of these risks. Both the PRA and ECB stressed that they would make use of the wider supervisory toolkit, including enforcement action, if firms did not adequately embed their approaches to managing climate-related risk. For more detail and a comparison of the findings, see our article here.

The PRA's feedback from the 2022/2023 round of written auditor reporting encouraged banks to establish clear plans and timeframes for developing climate accounting capabilities by: 

• Quantifying the impact of climate risks on expected credit losses;
• Focusing on controls to support the use of more forward-looking data in financial reporting; and 
• Quantifying the impact of climate risks on balance sheets and financial performance. 

In October 2023, the EBA published recommendations (PDF 2.4 MB) for regulators and standard-setters on how to reflect climate-related risks in the existing Pillar 1 framework (across credit, market, operational, liquidity and concentration risk). Although not aimed directly at banks, the recommendations provide useful insights into how the EBA will expect them to consider the prudential risks of climate change. 

The EBA recommendations followed a BoE report in March 2023 on climate-related risks and regulatory capital. While the BoE acknowledged that more research was required on how best to reflect climate-related risk in capital models, it also observed that “the absence of [banks' risk management] controls might suggest a greater quantum of capital will be required”. 

Managing the financial risks of climate change remains a key priority for the BCBS and the UK/EU supervisory authorities, as reflected in their published work programmes. Supervisory expectations will increase as banks' climate-related risk capabilities mature — therefore banks will need to continue investing in expertise, resources and methodologies.

Regulators and supervisors are still developing and refining their approaches to the prudential treatment of climate-related risks — see for example the BCBS's current proposals on Pillar 3 climate disclosures. However, this should not stop banks from continuing to build out their climate-related risk management capabilities in line with the BCBS Principles and other relevant requirements. They cannot afford to delay, especially given the risk of penalties or other supervisory enforcement action. 

KPMG is supporting banks across the industry to establish and develop their capabilities. In the table below, we outline some of the key challenges our clients are facing and how we can help: