The challenge of setting climate-related risk appetite for banks

IndustriesFinancial ServicesRegulatory Insights

Challenges of climate-related risk for banks

A critical element in incorporating climate-related risks into the overall risk management framework is to have a holistic and well-defined risk appetite statement that adequately reflects how climate risks could materialise as banks deliver on their strategy. Having such a risk appetite statement will help ensure climate-related risk management practices are better integrated.

Embedding climate-related risks into risk appetite statements is no mean feat, given the deep uncertainty and far-reaching nature of these risks combined with the challenges around data. It is no surprise that the European Central Bank (ECB) November 2021 report on ‘The state of climate and environmental risk management in the banking sector’ found that (i) less than 20% of the 112 significant institutions assessed had climate-related risks and (ii) most of the indicators in place did not comprehensively capture all relevant risks or portfolios.

Approach to updating risk appetite statements

According to the Prudential Regulatory Authority (PRA)’s supervisory statement on managing financial risks from climate change, banks should consider the following elements when including climate-related financial risks into their risk appetite statements:

  • Long-term financial interests, and how decisions today could affect future financial risks
  • Results of stress and scenario testing, for shorter and longer time horizons
  • Uncertainty around the timing and the channels through which the financial risks from climate change may materialise
  • Sensitivity of the balance sheet to changes in key risk drivers and external conditions

In formulating risk appetite statements, it is important to understand how climate-related risks and opportunities can manifest itself across banks’ business model. This will be key for identifying vulnerabilities to climate-related risks and determining activities which require closer attention. A top-down assessment can be done in the first instance, but this should be complemented with a bottom-up assessment which will delve deeper into climate-related impacts across business lines, geographies and key counterparties.

Qualitative statements should not only articulate the acceptable level of climate-related risks but also articulate banks’ climate commitments. These statements can be in the form of contributions to achieving specific net-zero emission targets, strategies to phase out or exclude environmentally endangering activities within asset portfolios and actions, or level of engagement with stakeholders (e.g. clients and suppliers). Qualitative statements should then be translated into quantitative metrics so that measurable limits can be cascaded across portfolios, business lines and key activities. Threshold levels should reflect the level of risks the bank is willing to take and should align with relevant climate-related targets the bank has committed to. As climate-related risks can crystallise beyond the usual 3–5-year planning horizon, quantitative metrics should align in terms of time horizon and be forward-looking. These metrics are expected to evolve as more knowledge is gained and results from climate-related scenario analysis become available.

Embedding risk appetite statement

With the PRA incorporating assessment of climate-related risk management into their supervisory approach, banks need to demonstrate tangible progress in quantifying climate-related risks and embedding these risks in their decision making. Therefore, developing climate-related risk appetite metrics and monitoring of these metrics will be critical for banks to satisfy forthcoming supervisory reviews. Embedding this risk appetite statement will involve:

  • Setting up appropriate governance arrangements to oversee adherence to risk appetite
  • Developing internal capabilities (people, processes and tools) around the management of climate-related risks
  • Identifying and remediating gaps around collection, aggregation and quality of relevant data
  • Establishing procedures for reporting internally and externally on climate-related risks and opportunities

References

Key contacts

Contact us

+44 20 7063 4000
Meet our local team
Discover our offices
Or use our contact form