How to manage and supervise climate-related financial risks – a view from the Basel Committee

The Basel Committee on Banking Supervision (BCBS) has published its “Principles for the effective management and supervision of climate-related financial risks” following a November 2021 consultation. The principles are designed to align supervisory expectations in respect of addressing climate-related financial risks by enhancing risk management and supervisory practices. Given the diverse and evolving practices in this developing area, the principles are intended as a common baseline for internationally active banks and supervisors so as to enable sufficient flexibility.

The first twelve principles are for banks and the last six for prudential supervisors of banks.

Principles for banks’ effective management of climate-related financial risks:

Since banks can be affected by climate-related financial risks regardless of their size, complexity or business model, the BCBS advises banks to manage such risks in a way that is proportionate to the nature, scale and complexity of their activities. In so doing, banks should consider the overall level of risk they are individually willing to accept. There is a high degree of uncertainty as to the timing when such risks may materialise. Consequently, the BCBS suggests that banks should take a prudent and dynamic approach to developing their risk management capabilities.

The BCBS principles cover a number of areas, where certain areas may contain more than one related principle:

Corporate governance: a bank will be expected to develop and implement a process in order to understand and assess the potential impacts of climate-related risks on its business and where it operates. Since climate-related financial risks can materialise over different time horizons, a bank should incorporate these risks into its overall business strategies and risk management frameworks. The board and senior management should assign and oversee climate-related responsibilities throughout the organisational structure. Finally, a bank should ensure effective management of climate-related financial risks by adopting appropriate policies, procedures and controls.

Internal controls: a bank should incorporate climate-related financial risks into its internal control framework across the following three lines of defence to ensure sound, comprehensive and effective identification, measurement and mitigation of material climate-related financial risks:

• risk assessments undertaken up front e.g. during client onboarding;
• assessments conducted under the risk function which is independent from the first line; and
• independent review and objective assurance work conducted under the internal audit function.

Capital and liquidity adequacy: a bank should identify and quantify climate-related financial risks. Its internal capital and liquidity adequacy assessments should incorporate those risks considered to be material over relevant time horizons. In addition, stress testing programmes should take these risks into account where appropriate.

Risk management process: a bank should identify, monitor and manage all climate-related financial risks that could materially impair its financial condition, including their capital and liquidity. A bank should ensure that its risk appetite and risk management framework take into account all material climate-related financial risks to which it is exposed and establish a reliable approach to identifying, measuring, monitoring and managing those risks.

Management monitoring and reporting: a bank should take into account climate-related financial risks when aggregating risk data and producing risk reports. In addition, it should ensure that its internal reporting systems can monitor material climate-related financial risks and produce timely information which will lead to effective board and senior management decision-making.

Comprehensive management of credit, market, liquidity, operational and other risks: a bank is expected to understand the impact of climate-related risk drivers on all of its risks: credit, market, liquidity, operational, strategic, reputational, regulatory, and litigation or liability risks. Thus, its management systems and processes should consider all material climate-related financial risks.

Scenario analysis: if appropriate, a bank should consider using scenario analysis in order to assess the resilience of its business models and strategies in respect of a number of climate-related situations. This would assist in determining the impact of climate-related risk drivers on its overall risk profile over a range of time periods.

Principles for the supervision of climate-related financial risks:

The BCBS principles aimed at supervisors of banks mirror the topics discussed above. The BCBS focused on two areas for its recommendations:

• prudential regulatory and supervisory requirements for banks; and
• responsibilities, powers and functions of supervisors.

The following principles are of note: when conducting supervisory assessments of a bank’s management of climate-related financial risks, a supervisor should ensure they use appropriate techniques and tools. In the event of material misalignment with supervisory expectations a supervisor should be able to follow up in an adequate way. Consequently, a supervisor should ensure they have enough resources and capacity in order to conduct such an assessment effectively.

Next steps: the principles are a good start to enable banks to address climate-related financial risks and may, in time, form a strong basis for the development of a legislative/regulatory framework throughout the BCBS’ member jurisdictions.

The BCBS expects implementation of the principles as soon as possible and it will monitor progress in member jurisdictions in order to foster a common understanding of supervisory expectations and to support the development, in a harmonised fashion, of strong practices across jurisdictions.

The BCBS has adopted a holistic approach to assessing, measuring and mitigating climate-related financial risks. As such, it considers potential supervisory, regulatory and disclosure-related measures for the banking system. The BCBS has indicated that it will provide an update on its work across these areas in due course. In addition, it will continue to co-operate with other international financial standard setters and public sector bodies in order to address climate-related financial risks in a co-ordinated and effective fashion.