BCBS principles for managing and supervising climate-related financial risks

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Managing climate-related financial risks

In November 2021, the Basel Committee on Banking Supervision (BCBS) issued a consultative document on the principles for effective management and supervision of climate-related financial risks.

Climate-related financial risks are one of the principal risks facing the banking sector right now, and whilst the BCBS believes that the core Basel framework is broad enough to encompass these issues, some additional guidance to address these risks would be beneficial for the banking sector by creating opportunities for best practice.

The consultative document sets 18 high-level principles divided into two categories; the management of climate-related risks principles 1-12, and guidance for prudential supervisors in principles 13-18. This document intends to improve practices related to the management of climate-related financial risks and provide a common baseline for international banks while maintaining flexibility given the degree of heterogeneity and evolving practices in this area.

The consultation paper remains open for comments until 16 February 2022.

Here is a synopsis of the suggested guidance which applies to the banks, i.e. principles 1-12.

Principle

Guidance

1

Corporate Governance - Banks should develop and implement a process for understanding and assessing climate-related risk drivers on their businesses and environments

  • Take material physical and transition risks drivers into consideration in business strategies
  • Evaluate how these risks could impact the bank's resilience over short, medium, and longer terms
  • Consider bank's exposure to structural changes in the economy, financial system and competitive landscape

Reference principles: BCP 14, SRP 30, and corporate governance principles for banks

2

Corporate Governance - Board and Senior Managers should assign climate-related responsibilities to members and committees and oversee climate-related financial risks

  • Integrate climate-related financial risks into the bank's business and strategies
  • Assign board and committee members oversight responsibility
  • Ensure that board and senior managers have adequate skills and experience to manage these risks
  • Create training programs, collaborations with expert organizations, and internal workshops
  • Ensure that the roles and responsibilities to identify and manage climate risks are sufficient through the bank

Reference principles: BCP 14, SRP 30, and corporate governance principles for banks

3

Corporate Governance - Banks should adopt the appropriate polices, controls and procedures to ensure effective management of climate-related financial risk

Policies, processes and controls should demonstrate that management of material climate-related financial risks are included across all relevant functions and business units

Reference principles: BCP 14, SRP 30, and corporate governance principles for banks

4

Internal Control Framework - Banks should incorporate climate related financial risks into their internal control frameworks across their three lines of defence

Using the three lines of defence the climate-related responsibilities and reporting should be clear

  • Frontline: During client onboarding a climate-related risk assessment should be conducted with staff having the appropriate skills
  • Second line: Risk function conducts an independent assessment, challenges the initial client assessment, while the compliance function ensures adherence to all rules and regulations
  • Third line: internal audit carries out regular reviews of the internal framework and systems

Reference principles: BCP 26, SRP 20, and SRP 30

5

Capital and Liquidity adequacy - Banks should incorporate identified and quantified climate-related financial risks deemed as material over relevant time horizons into their internal capital and liquidity assessment processes

  • Evaluate the solvency impact of climate-related financial risks within capital planning horizons
  • Include climate-related financial risks that could negatively affect capital position over time in the internal capital adequacy assessment process
  • Include climate-related financial risks that could cause net cash outflows or depletion of liquidity buffers in BAU and stress in the internal liquidity adequacy assessment process
  • Start building risk analysis capabilities to assess the links between climate-related financial risks and traditional financial risk types such as credit and liquidity risks

Reference principles: BCP15, BCP 24, SRP 20, SRP 30

6

Risk Management - Banks should identify, monitor and manage all climate-related financial risks that could impair their financial condition and ensure they are considered in their risk appetite and risk management frameworks

  • Conduct comprehensive assessments of climate-related financial risks
  • Set clear definitions and thresholds for materiality
  • Develop key risk indicators for effective management of material climate risks
  • Consider risk mitigation measures to the various types of risks
  • Monitor future developments and manage risks that may not yet be apparent

Reference principles: BCP 15, SRP 30

7

Management Monitoring and Reporting - Risk data aggregation and internal risk reporting practices should account for climate-related risks

  • IT Infrastructure and data governance should collect and aggregate climate-related financial risk data
  • Engage counterparties and clients to collect data and better understand transition strategies and risk profiles
  • Establish appropriate interval for updating internal risk report
  • Ensure reporting is timely and updated regularly
  • Develop qualitative or quantitative metric to assess, monitor and report climate-related financial risks

Reference principles: BCP 15, SRP 30, Principles for effective risk data aggregation and risk reporting

8

Comprehensive Management of Credit Risk - Banks should understand the impact of climate-related risk drivers in credit risk portfolios and ensure credit risk management systems and processes consider material climate-related financial risks

  • Have clearly articulated credit policies and processes to deal with climate-related credit risks
  • Incorporate material climate-related financial risks into the entire credit life cycle
  • Consider a range of risk mitigation options to control or minimize material climate-related credit risks
  • Consider setting limits on or applying appropriate alternative risk mitigation techniques

Reference principles: BCP 17, BCP 19, SRP 20

9

Comprehensive management of market risks - Banks should understand the impact of climate-related risk drivers on their market risk positions and ensure that market risk management systems and processes consider material climate-related financial risks

  • Evaluate potential risk of losses on or increased volatility in portfolios
  • Consider how pricing and availability of hedges in market to market could change due to climate-related risks
  • Analyse sudden shock scenario to understand and assess climate-related financial risks to the trading book

Reference principles: BCP 22

10

Comprehensive management of liquidity risks - Banks should understand the impact of climate-related risk drivers on their liquidity risk profiles and ensure that liquidity risk management systems and processes consider material climate-related financial risks

  • Assess the impacts of climate related financial risk on net cash outflows and the value of assets comprising liquidity buffers

Reference principles: BCP 24, Principles for sound liquidity risk management and supervision

11

Comprehensive management of operational and other risks -Banks should understand the impact of climate-related risk drivers on their operational risk and ensure that risk management systems and processes consider material climate-related risks

  • Assess the impact of climate-related risk drivers on their operations in general and their ability to continue providing critical operations
  • Assess the impact of climate-related risk drivers on other risks, such as strategic, reputational, regulatory compliance and liability risk, and take such risks, where material, into account as part of their risk management and strategy setting processes

Reference principles: BCP 25, Principles for the sound management of operational risk, Principles for operational resilience, SRP 20, SRP 30

12

Scenario Analysis - Banks should use scenario analysis and stress testing to assess resilience of business model and strategies to a range of plausible climate-related pathways

  • Build sufficient capacity and expertise to conduct climate scenario analysis that are proportionate to their size, business model and complexity
  • Explore the impacts of climate change and the transition to a low-carbon economy on the bank’s strategy and the resiliency of its business model
  • Identify relevant climate-related risk factors
  • Measure vulnerability to climate-related risks and estimate exposures and potential losses
  • Diagnose data and methodological limitations in climate risk management
  • Inform the adequacy of the bank’s risk management framework, including risk mitigation options

Stress testing reflects relevant climate-related financial risks for the bank. Scenario analysis should be sufficient to reflect the size, business model, and complexity of the bank. It should account for physical and transitional risk and a range of time horizons targeting different risk management objectives. Scenarios change frequently and the banks models should be adaptable and ready for changes.

Reference principles: BCP 15, Stress Testing

Key references:

BCBS Consultative Document - Principles for the effective management and supervision of climate-related financial risks
BCBS Guidelines - Corporate governance principles for banks
BCBS - Principles for effective risk data aggregation and risk reporting
BCBS - Principles for the sound management of operational risk
BCBS - Principles for operational resilience