BCBS Principles for the effective management of climate-related financial risks

These risks stem from the transition towards a low carbon economy and from the physical risks of damages due to extreme weather events. To address climate-related financial risks within the banking sector, the Basel Committee on Banking Supervision (BCBS) established a high-level Task Force on Climate-related Financial Risks in 2020. It contributes to the BCBS’s mandate to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability.

Both the BCBS’s Core principles for effective banking supervision¹ and the Supervisory Review and Evaluation Process (SREP) within the existing Basel Framework are considered sufficiently broad and flexible to accommodate additional supervisory responses to climate-related financial risks. It was felt, however, that supervisors and banks could benefit from the publication of the Principles for the effective management and supervision of climate-related financial risks². Through this publication, the BCBS seeks to promote a principles-based approach to improving risk management and supervisory practices regarding climate-related financial risks. The document contains principles directed to banks and principles directed to supervisory authorities. In this article, we present an overview of the principles directed to banks.

The BCBS published a draft of their Principles in November 2021. During the consultation phase, which lasted until February 2022, banks and supervisors could provide feedback. The BCBS incorporated their feedback in the final version of the Principles that were published in June 2022.

Principles for the management of climate-related financial risks

In total, twelve bank-focused principles are presented and grouped in eight categories. Each of the eight categories is briefly discussed below:

Corporate governance – Principles 1 to 3

The principles related to corporate governance state that banks first need to understand and assess the potential impact of climate risks on all fields they operate in. Subsequently, appropriate policies, procedures and controls need to be implemented to ensure effective management of the identified risks. Furthermore, roles and responsibilities need to be clearly defined and assigned throughout the bank. To successfully manage climate-related risks, banks should ensure an adequate understanding of climate-related financial risks and as well as adequate resources and skills at all relevant functions and business units within the bank. Finally, the board and senior management should ensure that all climate-related strategies are consistent with the bank’s stated goals and objectives.

Internal control framework – Principle 4

The fourth principle within the internal control framework subcategory requires banks to include clear definitions and assignment of climate-related responsibilities and reporting lines across all three lines of defense. Further requirements are then presented for each line of defense.

Capital and liquidity adequacy – Principle 5

After the identification and quantification of the climate-related financial risks, these risks need to be incorporated into banks’ Internal Capital (and Liquidity) Adequacy Assessment Process (ICLAAP). Banks should provide insights in which climate-related financial risks affect their capital and liquidity position. In addition, physical and transition risks relevant to a bank’s business model assessed as material over relevant time horizons, should be incorporated into their stress testing programs in order to evaluate the bank’s financial position under severe but plausible scenarios. Furthermore, the described incorporation in the ICLAAP to handle such financial risks, should be done iteratively and progressively, as the methodologies and data used to analyze these risks continue to mature over time.

Risk management process – Principle 6

The sixth principle connects to the previous one, as it states that a bank needs to identify, monitor and manage all climate-related financial risks that could materially impair their financial condition, including their capital resources and liquidity positions. The bank’s risk management framework should be comprehensive with respect to the (material) climate-related financial risks they are exposed to. Clear definitions and thresholds should be set for materiality. These need to be monitored closely and adjusted, if necessary, as climate-related risks are evolving.

Management monitoring and reporting – Principle 7

After ensuring that the risk framework is comprehensive, banks need to implement the monitoring and reporting of climate-related financial risks in a timely manner to facilitate effective decision-making. To achieve such reporting, a good data infrastructure should be in place at the bank. This allows it to identify, collect, cleanse, and centralize the data necessary to assess material climate-related financial risks. Furthermore, banks should actively collect additional data from clients and counterparties in order to develop a better understanding of their client’s transition strategies and risk profiles.

Management of credit, market, liquidity, operational risk – Principles 8 to 11

Banks should understand the impact of climate-related risk drivers on their credit risk profiles, market positions, liquidity risk profiles and operational risks. Clearly articulated credit policies and processes to identify, measure, evaluate, monitor, report and control or mitigate the impacts of material climate-related risk drivers on banks’ credit risk exposures should be in place. From a market risk perspective, banks should consider the potential losses in their portfolios due to climate-related risks. On the business operation and strategy side of banking activities, the impact of climate-related risks also plays a large role. For example, physical risks have to be taken into account when drafting business continuity plans. After understanding the different risks and their impacts, a range of risk mitigation options to control or mitigate climate-related financial risks need to be considered.

Scenario analysis – Principle 12

The final principle states that banks need to use scenario analysis to assess the resilience of their business models and strategies to a range of plausible climate-related pathways, and to determine the impact of climate-related risk drivers on their overall risk profile. Scenario analysis should reflect the overall relevant climate-related financial risks for banks, including both physical and transition risks. This analysis should be performed for different time horizons, both short- and long-term, and should be highly dynamic.

Changes to the BCBS risk framework draft and related publications

The final Principles have not changed much compared to the November 2021 consultation document. The most important changes are that the first principle, concerning corporate governance of banks, and the fifth principle, concerning capital and liquidity adequacy, have been extended. The corporate governance principle, for example, now also includes that banks should ensure that their internal strategies and risk appetite statements are consistent with any publicly communicated climate-related strategies and commitments. The capital and liquidity adequacy principle now includes a section requiring banks to incorporate material climate-related financial risks in their stress testing programs.

These twelve bank-focused principles, providing banks guidance on effective risk management of climate-related financial risks, can also be linked to the initiatives of other regulators such as the ECB. In November 2020, for example, the ECB provided a guide that describes how it expects institutions to consider climate-related and environmental risks, when formulating and implementing their business strategy, governance and risk management frameworks (the ECB expectations). These ECB expectations are in line with the BCBS Principles (and often more elaborate).

Zanders has gained relevant experience in implementing the ECB expectations at several Dutch banks. This experience ranges from risk identification and materiality assessments to the quantification of climate-related risks, ESG data frameworks, model validations, and scenario analysis. Please reach out to us if your bank is seeking support in implementing the BCBS Principles.

References
1) Basel Committee on Banking Supervision (2012). Core Principles for Effective Banking Supervision.
2) Basel Committee on Banking Supervision (2022). Principles for the effective management and supervision of climate-related financial risks.