Existing risk categories can capture climate risk drivers, Basel says

The Basel Committee on Banking Supervision says it has “not found any evidence” to support the creation of a separate risk category to address the drivers of climate risk – but indicates there will need to be more “granular” measurement of the changing climate’s impact on banks’ actual exposures.

The BCBS’s conclusions come in two reports released on 14 April – one exploring how climate risks affect the banking system, and another on how to measure climate risk. It says they are intended to be read in tandem.

The reports complain that existing work on climate risk had focused mainly on the impact on banks’ credit risk, and not enough on its impact on market risk – which it said could reduce financial asset values and potentially trigger “large, sudden and negative” price adjustments, and a breakdown in correlations between asset values that undermines risk management assumptions.

“There is little work that takes climate risk drivers all the way through to the impact on banks,” the risk drivers report says. It warns that banks’ business models and exposures can increase the severity of climate risk impacts, and that less developed economies are more susceptible to them.

It also notes there has still been little research on how climate risk drivers feed into banks’ financial risks – instead focusing on how specific risk drivers impact on “narrowly defined sectors of particular economies, individual markets, or top-down assessments of the macro economy as a whole”.

But it also notes that the lack of research on banks’ climate-related risks is in part due to a lack of data availability, saying that the emergence of climate-related stress testing in some jurisdictions “may partially address this information gap”.

It endorses using the Basel framework’s existing risk categories to capture climate-related risks, saying it had “not found any evidence” to support creating an additional risk category to address climate risk. “While climate risks have distinctive elements, they can be reflected through the traditional risk categories,” it concludes.

In its methodology report, the BCBS calls for “granular and forward-looking” measurements of climate risk that take its unique features into account, with a “particularly high exposure granularity” to assess the physical risks of climate change and the risks arising from the transition to a low-carbon economy.

It says that so far measurement has been more successful at capturing banks’ exposures to transition risk, while “progress has been less tangible in empirically capturing banks’ exposures to physical risks”.

Mayer Brown partners Paul Forrester and Andrew Olmem, and senior associate Matthew Bisanz, in a 15 April client note on the reports, note that the reports come in the context of the US Federal Reserve’s recent announcement of a Financial Stability Climate Committee specifically tasked with addressing climate-related risks to financial stability in March.

“These BCBS reports show that, while significant progress has been made in the assessment and quantification of climate-related financial risks by banks and their supervisors, further work remains,” the client note reads.

“The BCBS still has significant methodological and quantitative issues to resolve on how climate change risk impacts the financial system before this risk can be incorporated into bank regulatory requirements.”

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