Basel playing catch-up on climate risk, say experts

Individual regulators have already gone further in encouraging transition

The Bank for International Settlements, Basel
The Bank for International Settlements building, home to the Basel Committee
Photo: Ulrich Roth

The Basel Committee on Banking Supervision’s first foray into climate risk analysis is several steps behind some of its most progressive member states, say experts. That could change if global policymakers provide a more ambitious mandate, but there are also doubts about whether the existing Basel framework is the right context for tackling the issue.

“It seems that they are having a conversation that [reflects] where we were in 2015,” says Matthew Scott, senior director at advisory firm Willis Towers Watson and former head of the Bank of England’s Climate Hub.

In particular, some national regulators have begun to frame policy with the explicit intention of encouraging banking sector transition towards financing a sustainable economy. Sarah Breeden, the BoE’s climate lead, said in a speech in July 2020: “[Climate change] is a collective action problem where seemingly rational individual inaction makes our collective future problems much bigger.”

By contrast, the focus of the two Basel papers launched on April 14 – on transmission mechanisms and measurement methodologies for climate risk – is largely reactive, examining how “climate related financial risks could impact the safety and soundness of individual financial institutions”.

This less activist approach also means the Basel Committee reports are not explicit about the interdependence between the impacts of the two main categories of climate risk on banks’ asset quality. These are the physical risks of climate change itself, and the transition risks – the impact of policy decisions designed to cut carbon emissions.

“Several features relating to climate change are increasing the likelihood that these risks may be dependent on each other, which may necessitate their being considered jointly,” the committee found.

By contrast, work by the Financial Stability Board (FSB) and the group of 83 national regulators called the Network for Greening the Financial System (NGFS) has already been more categorical, emphasising that a later response to climate change will potentially cause an increase in both physical and transition risks.

“The NGFS scenarios and the scenarios that banks and insurers are doing implicitly… take a view that it is self-evident that an orderly transition is the best way forward,” says Scott.

The November 2020 report on climate change by the FSB stated: “An increased materialisation of physical risks could prompt more significant policy action to stem them. This could then give rise to a disorderly transition to a lower-carbon economy, and the crystallisation of transition risks.”

Slow road to consensus

These reports are just a first step by the Basel Committee. Wim Bartels, global co-head of sustainability reporting at KPMG and a member of the FSB Taskforce for Climate-Related Financial Disclosures, says he is relieved the Basel reports didn’t try to run far ahead of the industry. But he also feels the committee should not solely limit its ambition to the measurement of climate change risk and transmission channels.

“The banks that survive and win may not be the banks that have the most precise data or can claim perfect capital levels thanks to a particular calculation, but the ones that are able to adapt sufficiently quickly, that have the right strategies as a whole and capabilities within the teams and can work in a way that is – to use that famous word – agile,” says Bartels.

Courtesy of the Federal Reserve Bank of New York
Photo: Courtesy of the Federal Reserve Bank of New York
Kevin Stiroh, New York Federal Reserve

To some extent, the committee’s more understated approach reflects the fact that its standards are meant to be binding on members, so it tries to reach a consensus before proceeding. By contrast, the NGFS is a voluntary organisation, so it has more space to advance rapidly.

The New York Federal Reserve’s Kevin Stiroh, who chairs Basel’s task force on climate-related financial risks, has already made clear that its approach will be gradual and sequential. At this stage, few jurisdictions have both their central bank and government aligned on this policy issue – essentially only the BoE and European Central Bank have been given explicit mandates by policymakers.

That could be about to change, especially following the election of Joe Biden as US president in November last year. On April 22, 40 world leaders met on the fifth anniversary of the Paris Agreement with the aim of setting tangible targets to achieve their commitment to carbon emission reductions.

This work should in turn feed through to the FSB, which is due to deliver a report to the G20 on climate-related disclosures and data in July 2021, and a roadmap for tackling climate risk in the financial sector in November.

Radical uncertainty

As a result, policymakers could give the Basel Committee a clearer mandate by the end of this year to incentivise transition. However, experts with experience of climate risk stress testing exercises carried out or currently underway in the UK, France and the Netherlands question whether the Basel capital framework is suitable for tackling this issue.

Recent research by the Bank for International Settlements has described climate change as a ‘green swan’ that invalidates risk models built on past data and includes the potential for very high-impact tail-risk events. A report published by University College London in 2019 also warned regulators against a focus on filling in data gaps, because the “radical uncertainty” of climate risk is likely to prevent the efficient pricing of it.

The committee’s focus on measurement methodologies suggests these arguments have not yet been fully integrated into its thinking.

“The Basel reports take the current context and boundaries of risk frameworks as a given… It could have been highlighted more explicitly that climate-related risks require looking at risk management through a different lens,” says Bartels.

The Basel reports acknowledge differences of opinion among regulators about where to fit climate risk into the three pillars of the capital framework – regulatory capital requirements (Pillar 1), supervisory add-ons (Pillar 2) and risk disclosure (Pillar 3).

If we think it unlikely that Pillar 3 disclosure will enable the repricing of climate risk in time to meet the Paris Agreement’s 2050 targets, then the Basel Committee should broaden its analysis
Jérôme Courcier, French Corporate Social Responsibility Observatory

Jérôme Courcier, an expert at the French Corporate Social Responsibility Observatory and former corporate and social responsibility officer at Crédit Agricole, is concerned that the committee’s focus on stress testing and scenario analysis will lead it to rely too heavily on Pillar 3.

“It’s not the solution, it’s just a starter,” says Courcier. “If we think it unlikely that Pillar 3 disclosure will enable the repricing of climate risk in time to meet the Paris Agreement’s 2050 targets, then the Basel Committee should broaden its analysis.”

But others are sceptical that capital requirements could work either, because the time horizon and uncertainty of climate risks are so different from the existing Basel methodology of calculating precise risk and capital numbers over the short-to-medium term.

“The timelines climate risk analysis requires simply don’t fit within the existing capital framework for credit risk allocation, to give one example,” says Benoit Genest, a partner at consultancy Chappuis Halder.

For this reason, Bartels thinks the focus should be on the need to “draw and lead the market” rather than offering “definitive answers”. To support banks’ efforts to integrate climate risk into their business strategy and risk management processes, the committee can provide guidance that helps answer the question: “What should that look like?” he says.

Editing by Philip Alexander

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