Early October, the Basel Committee on Banking Supervision (BCBS) published a report[1] on the 2023 banking turmoil that involved the failure of several US banks as well as Credit Suisse. The report draws lessons for banking regulation and supervision which may ultimately lead to changes in banking regulation as well as supervisory practices. In this article we summarize the main findings of the report[2]. Based on the report’s assessment, the most material consequences for banks, in our view, could be in the following areas:

• Reparameterization of the LCR calculation and/or introduction of additional liquidity metrics
• Inclusion of assets accounted for at amortized cost at their fair value in the determination of regulatory capital
• Implementation of extended disclosure requirements for a bank's interest rate exposure and liquidity position
• More intensive supervision of smaller banks, especially those experiencing fast growth and concentration in specific client segments
• Application of the full Basel III Accord and the Basel IRRBB framework to a larger group of banks

Bank failures and underlying causes

The BCBS report first describes in some detail the events that led to the failure of each of the following banks in the spring of 2023:

• Silicon Valley Bank (SVB)
• Signature Bank of New York (SBNY)
• First Republic Bank (FRB)
• Credit Suisse (CS)

While each failure involved various bank-specific factors, the BCBS report highlights common features (with the relevant banks indicated in brackets).

• Long-term unsustainable business models (all), in part due to remuneration incentives for short-term profits
• Governance and risk management did not keep up with fast growth in recent years (SVB, SBNY, FRC)
• Ineffective oversight of risks by the board and management (all)
• Overreliance on uninsured customer deposits, which are more likely to be withdrawn in a stress situation (SVB, SBNY, FRC)
• Unprecedented speed of deposit withdrawals through online banking (all)
• Investment of short-term deposits in long-term assets without adequate interest-rate hedges (SVB, FRC)
• Failure to assess whether designated assets qualified as eligible collateral for borrowing at the central bank (SVB, SBNY)
• Client concentration risk in specific sectors and on both asset and liability side of the balance sheet (SVB, SBNY, FRC)
• Too much leniency by supervisors to address supervisory findings (SVB, SBNY, CS)
• Incomplete implementation of the Basel Framework: SVB, SBNY and FRB were not subject to the liquidity coverage ratio (LCR) of the Basel III Accord and the BCBS standard on interest rate risk in the banking book (IRRBB)

Of the four failed banks, only Credit Suisse was subject to the LCR requirements of the Basel III Accord, in relation to which the BCBS report includes the following observations:

• A substantial part of the available high quality liquid assets (HQLA) at CS was needed for purposes other than covering deposit outflows under stress, in contrast to the assumptions made in the LCR calculation
• The bank hesitated to make use of the LCR buffer and to access emergency liquidity so as to avoid negative signalling to the market

Although not part of the BCBS report, these observations could lead to modifications to the LCR regulation in the future.

Lessons for supervision

With respect to supervisory practices, the BCBS report identifies various lessons learned and raises a few questions, divided into four main areas:

1. Bank’s business models

• Importance of forward-looking assessment of a bank’s capital and liquidity adequacy because accounting measures (on which regulatory capital and liquidity measures are based) mostly are not forward-looking in nature
• A focus on a bank’s risk-adjusted profitability
• Proactive engagement with ‘outlier banks’, e.g., banks that experienced fast growth and have concentrated funding sources or exposures
• Consideration of the impact of changes in the external environment, such as market conditions (including interest rates) and regulatory changes (including implementation of Basel III)

2. Bank’s governance and risk management

• Board composition, relevant experience and independent challenge of management
• Independence and empowerment of risk management and internal audit functions
• Establishment of an enterprise-wide risk culture and its embedding in corporate and business processes.
• Senior management remuneration incentives

3.Liquidity supervision

• Do the existing metrics (LCR, NSFR) and supervisory review suffice to identify start of material liquidity outflows?
• Should the monitoring frequency of metrics be increased (e.g., weekly for business as usual and daily or even intra-day in times of stress)?
• Monitoring of concentration risks (clients as well as funding sources)
• Are sources of liquidity transferable within the legal entity structure and freely available in times of stress?
• Testing of contingency funding plans

4. Supervisory judgment

• Supplement rules-based regulation with supervisory judgment in order to intervene pro-actively when identifying risks that could threaten the bank’s safety and soundness. However, the report acknowledges that a supervisor may not be able to enforce (pre-emptive) action as long as an institution satisfies all minimum requirements. This will also depend on local legislative and regulatory frameworks

Lessons for regulation

In addition, the BCBS report identifies various potential enhancement to the design and implementation of bank regulation in four main areas:

1. Liquidity standards

• Consideration of daily operational and intra-day liquidity requirements in the LCR, based on the observation that a material part of the HQLA of CS was used for this purpose but this is not taken into account in the determination of the LCR
• Recalibration of deposit outflows in the calculation of LCR and NSFR, based on the observation that actual outflow rates at the failed banks significantly exceeded assumed outflows in the LCR and NSFR calculations
• Introduction of additional liquidity metrics such as a 5-day forward liquidity position, survival period and/or non-risk based liquidity metrics that do not rely on run-off assumptions (similar to the role of the leverage ratio in the capital framework)

2. IRRBB

• Implementation of the Basel standard on IRRBB, which did not apply to the US banks, could have made the interest rate risk exposures transparent and initiated timely action by management or regulatory intervention.
• More granular disclosure, covering for example positions with and without hedging, contractual maturities of banking book positions and modelling assumptions 

3. Definition of regulatory capital

• Reflect unrealised gains and losses on assets that are accounted for at amortised cost (AC) in regulatory capital, analogous to the treatment of assets that are classified as available-for-sale (AFS). This is supported by the observation that unrealised losses on fixed-income assets held at amortised cost, resulting from to the sharp rise in interest rates, was an important driver of the failure of several US banks when these assets were sold to create liquidity and unrealised losses turned into realised losses. The BCBS report includes the following considerations in this respect:
  • If AC assets can be repo-ed to create liquidity instead of being sold, then there is no negative impact on the financial statement
  • Treating unrealised gains and losses on AC assets in the same way as AFS assets will create additional volatility in earnings and capital
  • The determination of HQLA in the LCR regulation requires that assets are measured at no more than market value. However, this does not prevent the negative capital impact described above
• Reconsideration of the role, definition and transparency of additional Tier-1 (AT1) instruments, considering the discussion following the write-off of AT1 instruments as part of the take-over of CS by UBS

4. Application of the Basel framework

• Broadening the application of the full Basel III framework beyond internationally active banks and/or developing complementary approaches to identify risks at domestic banks that could pose a threat to cross-border financial stability. The events in the spring of this year have demonstrated that distress at relatively small banks that are not subject to the (full) Basel III regulation can trigger broader and cross-border systemic concerns and contagion effects.
• Prudent application of the ‘proportionality’ principle to domestic banks, based on the observation that financial distress at such banks can have cross-border financial stability effects
• Harmonization of approaches that aim to ensure that sufficient capital and liquidity is available at individual legal entity level within banking groups

Conclusion

The BCBS report identifies common shortcomings in bank risk management practices and governance at the four banks that failed during the 2023 banking turmoil and summarizes key take-aways for bank supervision and regulation.

The identified shortcomings in bank risk management include gaps in the management of traditional banking risks (interest rate, liquidity and concentration risks), failure to appreciate the interrelation between individual risks, unsustainable business models driven by short-term incentives at the expense of appropriate risk management, poor risk culture, ineffective senior management and board oversight as well as a failure to adequately respond to supervisory feedback and recommendations.

Key take-aways for effective supervision include enforcing prompt action by banks in response to supervisory findings, actively monitoring and assessing potential implications of structural changes to the banking system, and maintaining effective cross-border supervisory cooperation.

Key lessons for regulatory standards include the importance of full and consistent implementation of Basel standards as well as potential enhancements of the Basel III liquidity standards, the regulatory treatment of interest rate risk in the banking book, the treatment of assets that are accounted for at amortised cost within regulatory capital and the role of additional Tier-1 capital instruments.

The BCBS report is intended as a starting point for discussion among banking regulators and supervisors about possible changes to banking regulation and supervisory practices. For those interested in engaging in discussions related to the insights and recommendations in the BCBS report, please feel free to contact Pieter Klaassen.

[1] Report on the 2023 banking turmoil (bis.org) (accessed on October 19, 2023)

[2] Although recognized as relevant in relation to the banking turmoil, the BCBS report explicitly excludes from its consideration the role and design of deposit guarantee schemes, the effectiveness of resolution arrangements, the use and design of central bank lending facilities and FX swap lines, and public support measures in banking crises.

Main causes of volatility in SOT outcomes

The severely changed market circumstances evidence that, despite all efforts, the impact on the IRRBB framework could not be fully foreseen. The challenge of certain banks to comply with one of the key regulatory metrics defined in the context of IRRBB, the SOT on EVE, illustrates this. Indeed, even if regularities are assumed, there are still several key model choices that turn out to materialize in today’s interest rate environment:

• Interest rate dependency in behavioral models: Behavioral models, in particular when these include interest rate-dependent relationships, typically exhibit a large amount of convexity. In some cases, convexity can be (significantly) overstated due to particular modeling choices, in turn contributing to a violation of the EVE SOT criterium. Some (small and mid-sized) banks, for example, apply the so-called ‘scenario multipliers’ and/or ‘scalar multipliers’ defined within the BCBS-standardized framework for incorporating interest rate-dependent relationships in their behavioral models. These multipliers assume a linear relationship between the modeled variable (e.g., prepayment rate) and the scenario, whereas in practice this relationship is not always linear. In other cases, the calibration approach of certain behavioral models is based on interest rates that have been decreasing for 10 to 15 years, and therefore may not be capable to handle a scenario in which a severe upward shock is added to a significantly increased base case yield curve.
• Level and shape of the yield curve: Related to the previous point, some behavioral models are based on the steepness (defined as the difference between a ‘long tenor’ rate and a ‘short tenor’ rate) of the yield curve. As can be seen in Figure 1, the steepness changed significantly over the past two years, potentially leading to a high impact associated with the behavioral models that are based on it. Further, as illustrated in Figure 2, the yield curve has flattened over time and recently even turned into an inverse yield curve. When calculating the respective forward rates that define the steepness within a particular behavioral model, the downward trend of this variable that results due to the inverse yield curve potentially aggravates this effect.

Figure 1: Development of 3M EURIBOR rate and 10Y swap rate (vs. 3M EURIBOR) and the corresponding 'Steepness'

Figure 2: Development of the yield curve over the period December 2021 to March 2023.

• Hidden vulnerability to ‘down’ scenarios: Previously, the interest rates were relatively close to, or even below, the EBA floor that is imposed on the SOT. Consequently, the ‘at-risk’ figures corresponding to scenarios in which (part of) the yield curve is shocked downward, were relatively small. Now that interest rates have moved away from the EBA floor, hidden vulnerability to ‘down’ scenarios become visible and likely the dominating scenario for the SOT on EVE.
• Including ‘margin’ cashflows: Some banks determine their SOT on EVE including the margin cashflows (i.e., the spread added to the swap rate), while discounting at risk-free rates. While this approach is regulatory compliant, the inclusion of margin cashflows leads to higher (shocked) EVE values, and potentially leads to, or at least contributes to, a violation of the EVE threshold.

What can banks do?

Having identified the above issues, the question arises as to what measures banks should consider. Roughly speaking, two categories of actions can be distinguished. The first category encompasses actions that resolve an inadequate reflection of the actual risk. Examples of such actions include:

• Identify and re-solve unintended effects in behavioral models: As mentioned above, behavioral models are key to determine appropriate EVE SOT figures. Next to revisiting the calibration approach, which typically is based on historical data, banks should assess to what extent there are unintended effects present in their behavioral models that adversely impact convexity and lead to unrepresentative sensitivities and unreliably shocked EVE values.
• Adopt a pure IRR approach: An obvious candidate action for banks that still include margins in their cashflows used for the EVE SOT, is to adopt a pure interest rate risk view. In other words, align the cashflows with its discounting. This requires an adequate approach to remove the margin components from the interest cashflows.

The second category of actions addresses the actual, i.e., economic, risk position of bank. One could think of the following aspects that contribute to steering the EVE SOT within regulatory thresholds:

• Evaluate target mismatch: As we wrote in our article ‘What can banks do to address the challenges posed by rising interest rates’, a bank’s EVE is most likely negatively affected by the rise in rates. The impact is dependent on the duration of equity taken by the bank: the higher the equity duration, the larger the decline in EVE when rates rise (and hence a higher EVE risk). In light of the challenges described above, a bank should consider re-evaluating the target mismatch (i.e. the duration of equity).
• Consider swaptions as an additional hedge instrument: Convexity, in essence, cannot be hedged with plain vanilla swaps. Therefore, several banks have entered into ‘far out of the money’ swaptions to manage negative convexity in the SOT on EVE. From a business perspective, these swaptions result in additional, but accepted costs and P&L volatility. In case of an upward-sloping yield curve, the costs can be partly offset since the bank can increase its linear risk position (increase duration), without exceeding the EVE SOT threshold. This being said, swaptions can be considered a complex instrument that presents certain challenges. First, it requires valuation models – and expertise on these models – to be embedded within the organization. Second, setting up a heuristic that adequately matches the sensitivities of the swaptions to those of the commercial products (e.g., mortgages) is not a straightforward task.

How can Zanders support?

Zanders is thought leader in supporting banks with IRRBB-related topics. We enable banks to achieve both regulatory compliance and strategic risk goals, by offering support from strategy to implementation. This includes risk identification, formulating a risk strategy, setting up an IRRBB governance and framework, policy or risk appetite statements. Moreover, we have an extensive track record in IRRBB and behavioral models, hedging strategies, and calculating risk metrics, both from a model development as well as a model validation perspective.

Are you interested in IRRBB related topics? Contact Jaap Karelse, Erik Vijlbrief (Netherlands, Belgium and Nordic countries) or Martijn Wycisk (DACH region) for more information.

The Zanders purpose

Our purpose is to deliver financial performance when it counts, to propel organizations, economies, and the world forward.

With every improvement, fraudsters look for and find new opportunities to exploit. When the opportunity arises, some people see a big incentive or pressure to commit fraud, and most will be able to justify to themselves why it is acceptable to commit fraud (as shown in the Fraud triangle – Figure 1). Unfortunately, the impact of fraud on organizations, individuals and society in general is substantial.

More simply put, the EBA was asked to investigate whether the current prudential framework properly captures environmental and social risks. In response, the EBA published a Discussion Paper (DP) [1] in May 2022 to collect input from stakeholders such as academia and banking professionals.

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.

In the below overview, we present an overview of the main ESG-related publications from the European Commission (EC), the European Central Bank (ECB), and the European Banking Authority (EBA).

This is complemented by the most important timelines that are stipulated in these regulations and guidelines. Additional regulations and guidelines that are expected for the next couple of years are also highlighted.

If you want to discuss any of them, don’t hesitate to reach out to our subject matter experts.

In total 104 banks participated in the stress test that was intended as a learning exercise, for the ECB and the participating banks alike. In this article we provide a brief overview of the main results.

The ECB’s goal with the climate risk stress test was to assess the progress banks have made in developing climate risk stress-testing frameworks and the corresponding projections, as well as understanding the exposures of banks with respect to both transition and physical climate change risks. The stress test therefore consisted of three modules: 1) a qualitative questionnaire to assess the bank’s climate risk stress testing capabilities, 2) two climate risk metrics showing the sensitivity of the banks’ income to transition risk and their exposure to carbon emission-intensive industries, and 3) constrained bottom-up stress test projections for four scenarios specified by the ECB¹. The third module only had to be completed by 41 directly supervised banks to limit the burden for some of the smaller banks included in the climate risk stress test.

An understatement of the true risk

The constrained bottom-up stress test projections show that the combined market and credit risk losses for the 41 banks in the sample amount to approximately EUR 70 billion in the short-term disorderly transition scenario. The ECB emphasizes that this probably is an understatement of the true risk, because it does not consider the scenarios underlying the stress test to be ‘adverse’. Second round economic effects from climate risk changes have, for example, not been factored in. Furthermore, only a third of the total exposures of the 41 banks were in scope and, on top of that, the ECB considers the banks’ modeling capabilities to be ‘rudimentary’ in this stage: they report that around 60% of the banks do not yet have a well-integrated climate risk stress testing framework in place, and they expect that it will take several years before banks achieve this. Even though banks are not meeting the ECB’s expectations yet, the ECB does conclude that banks have made considerable progress with respect to their climate stress testing capabilities.

Be aware of clients’ transition plans

A further analysis of the results shows that the share of interest income related to the 22 most carbon-intensive industries amounts to more than 60% of the total non-financial corporate interest income (on average for the banks in the sample). Interestingly, this is higher than the share of these sectors (around 54%) in the EU economy in terms of gross added value. The ECB argues that banks should be very much aware of the transition plans of their clients to manage potential future transition risks in their portfolio. The exposure to physical risks is much more varied across the sample of banks. It primarily depends on the geographical location of their lending portfolios’ assets.

The ECB points out that only a few banks account for climate risk in their credit risk models. In many cases, the credit risk parameters are fairly insensitive to the climate change scenarios used in the stress test. They also report that only one in five banks factor climate risk into their loan origination processes. A final point of attention is data availability. In many cases, proxies instead of actual counterparty data have been used to measure (for example) greenhouse gas emissions, especially for Scope 3. Consequently, the ECB is also promoting a higher level of customer engagement to improve in this area.

Many deficiencies, data gaps and inconsistencies

The outcome of the climate risk stress test will not have direct implications for a bank’s capital requirements, but it will be considered from a qualitative point of view as part of the Supervisory Review and Evaluation Process (SREP). This will be complemented by the results from the ongoing thematic review that is focused on the way banks consider climate-related and environmental risks into their risk management frameworks. The combination will indicate to the ECB how well a bank is meeting the expectations laid down in the ‘Guide on climate-related and environmental risks’ that was published by the ECB in November 2020.

The ECB notes that the exercise revealed many deficiencies, data gaps and inconsistencies across institutions and expects banks to make substantial further progress in the coming years. Furthermore, the ECB concludes that banks need to increase customer engagement to obtain relevant company-level information on greenhouse gas emissions, as well as to invest further in the methodological assumptions that are used to arrive at proxies.

If you are looking for support with the integration of Environmental, Social, and Governance risk factors into your existing risk frameworks, please reach out to us.

Notes
1) See our earlier article on the ECB’s climate stress test methodology for more details.

The last three to four years have seen a rapid increase in the number of publications and guidance from regulators and industry bodies. Environmental risk is currently receiving the most attention, triggered by the alarming reports from the Intergovernmental Panel on Climate Change (IPCC). These reports show that it is a formidable, global challenge to shift to a sustainable economy in order to reduce environmental impact.

The Working Group II contribution to the IPCC’s Sixth Assessment Report states that “climate change is a grave and mounting threat to our wellbeing and a healthy planet”. It is a formidable, global challenge to transition to a sustainable economy before time is running out. Banks have an important role to play in this transition. By stepping up to this role now, banks will be better prepared for the future, and reap the benefits along the way.

In the Paris Agreement (or COP21), adopted in December 2015, 196 parties agreed to limit global warming to well below 2.0°C, and preferably to no more than 1.5°C. To prevent irreversible impacts to our climate, the IPCC stresses that the increase in global temperature (relative to the pre-industrial era) needs to remain below 1.5°C. To achieve this target, a rapid and unprecedented decrease in the emission of greenhouse gasses (GHG) is required. With CO2 emissions still on the rise, as depicted in Figure 1, the challenge at hand has increased considerably in the past decade.

Figure 1 – Annual CO2 emissions from fossil fuels.

To further illustrate this, Figure 2 depicts for several starting years a possible pathway in CO2 reductions to ensure global warming does not exceed 2.0°C. Even under the assumption that CO2 emissions have already peaked, it becomes clear that the required speed of CO2 reductions is rapidly increasing with every year of inaction. We are a long way from limiting global warming to 2.0°C. This even holds under the assumption that all countries’ pledges to reduce GHG emissions will be achieved, as can be observed in Figure 3.

To quote the IPCC Working Group II co-chair Hans-Otto Pörtner: “Any further delay in concerted anticipatory global action on adaptation and mitigation will miss a brief and rapidly closing window of opportunity to secure a livable and sustainable future for all.”

Figure 2 – CO2 reduction need to limit global warming.

Figure 3 – Global GHG emissions and warming scenario’s.

The role of banks in the transition – and the opportunities it offers

Historically, banks have been instrumental to the proper functioning of the economy. In their role as financial intermediaries, they bring together savers and borrowers, support investment, and play an important role in facilitating payments and transactions. Now, banks have the opportunity to become instrumental to the proper functioning of the planet. By allocating their available capital to ‘green’ loans and investments at the expense of their ‘brown’ counterparts, banks can play a pivotal role in the transition to a sustainable economy. Banks are in the extraordinary position to make a fundamentally positive contribution to society. And even better, it comes with new opportunities.

The transition to a sustainable economy requires huge investments. It ranges from investments in climate change adaption to investments in GHG emission reductions: this covers for example investments in flood risk warning systems and financing a radical change in our energy mix from fossil-fuel based sources (like coal and natural gas) to clean energy sources (like solar and wind power). According to the Net Zero by 2050 Report from the International Energy Agency (IEA)², the annual investments in the energy sector alone will increase from the current USD 2.3 trillion to USD 5.0 trillion by 2030. Hence, across sectors, the increase in annual investments could easily be USD 3.0 to 4.0 trillion. As much as 70% of this investment may need to be financed by the private sector (including banks and other financial institutions)³. To put this in perspective, the total outstanding credit to non-financial corporates currently stands at USD 86.3 trillion⁴. Assuming an average loan maturity of 5 years, this would translate to a 12-16% increase in loans and investments by banks on a global level. Hence, the transition to a sustainable economy will open up a large market for banks through direct investments and financing provided to corporates and households.

The transition to a sustainable economy is also triggering product development. The Climate Bonds Initiative (CBI) for example reports that the combined issuance of Environmental, Social, and Governance (ESG) bonds, sustainability-linked bonds and transition debt reached almost USD 500 billion in 2021H1, representing a 59% year-on-year growth rate. Other initiatives include the introduction of ‘green’ exchange-traded funds (ETFs) and sustainability-linked derivatives. The latter first appeared in 2019 and they provide an incentive for companies to achieve sustainable performance targets. If targets are met, a company is for example eligible for a more attractive interest coupon. Again, this is creating an interesting market for banks.

By embracing the transition, with all the opportunities that it offers, banks are also bracing themselves for the future. Banks that adopt climate change-resilient business models and integrate climate risk management into their risk frameworks will be much better positioned than banks that do not. They will be less exposed to climate-related risks, ranging from physical and transition risks to risks stemming from a reputational perspective or litigation, also justifying lower capital requirements. The early adaptors of today will be the leaders of tomorrow.

A roadmap supporting the transition

How should a bank approach this transition? As depicted in Figure 4, we identify four important steps: target setting, measurement and reporting, strategy and risk framework, and engaging with clients.

Figure 4 – The roadmap supporting the transition to a sustainable economy.

Target setting

The starting point for each transition is to set GHG emission targets in alignment with emission pathways that have been established by climate science. One important initiative that can support banks in setting these targets is the Science Based Targets initiative (SBTi). This organization supports companies to set targets in line with the goals of the Paris Agreement. Unlike many other companies, the majority of a bank’s GHG emissions are outside their direct control. They can influence, however, their so-called financed emissions, which are the GHG emissions coming from their lending and investment portfolios. The SBTi has developed a framework for banks that reflects this. It encourages banks to use the Absolute Contraction approach that requires a 2.5% (for a well-below 2.0°C target) or 4.2% (for a 1.5°C target) annual reduction in GHG emissions. A clear emission pathway guides banks in the subsequent steps of the transition process.

Measurement and reporting

With targets in place, the next important step for a bank is to determine their level of GHG emissions: both for scope 1 and 2 (the GHG emissions they control) and for scope 3 (the financed emissions). Important initiatives for the quantification of the financed emissions are the Paris Agreement Capital Transition Assessment (PACTA) and the Platform Carbon Accounting Financials (PCAF). PCAF is a Dutch initiative to deliver a global, standardized GHG accounting and reporting approach for financial institutions (building on the GHG Protocol). PACTA enables banks to measure the alignment of financial portfolios with climate scenarios.

By keeping track of the level of GHG emissions on an annual basis, banks can assess whether they are following their selected emission pathway. Reporting, in line with the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD), will contribute to a greater understanding of climate risks with their investors and other stakeholders.

Strategy and risk framework

Setting targets and measuring the current level of GHG emissions are necessary but not sufficient conditions to achieve a successful transition. Climate change risk needs to be fully integrated into a bank’s strategy and its risk framework. To assess the climate change-resilience of a bank’s strategy, a logical first step is to understand which climate change risks are material to the organization (e.g., by composing a materiality matrix). Subsequently, studying the transmission channels of these risks using scenario analysis and/or stress testing creates an understanding of what parts of the business model and lending portfolio are most exposed. This could lead to general changes in a bank’s positioning, but these risks should also be factored into the bank’s existing risk framework. Examples are the loan origination process, capital calculations, and risk reporting.

Engaging with clients

A fourth step in the game plan to successfully support the transition is for a bank to actively engage with its clients. A dialogue is required to align the bank’s GHG emission targets with those of its clients. This extends to discussing changes in the operations and/or business model of a client to align with a sustainable economy. This also may include timely announcing that certain economic activities will no longer be financed, and by financing client’s initiatives to mitigate or adapt to climate change: e.g., financing wind turbines for clients with energy- or carbon-intensive production processes (like cement or aluminium) or financing the move of production locations to less flood-prone areas.

Conclusion

Banks are uniquely positioned to play a pivotal role in the transition to a sustainable economy. The transition is already providing a wide range of opportunities for banks, from large financing needs to the introduction of green bonds and sustainability-linked derivatives. At the same time, it is of paramount importance for banks to adopt a climate change-resilient strategy and to integrate climate change risk into their risk frameworks. With our extensive track record in financial and non-financial risk management at financial institutions, Zanders stands ready to support you with this ambitious, yet rewarding challenge.

ESG risk management and Zanders

Zanders is currently supporting several clients with the identification, measurement, and management of ESG risks. For a start, we are supporting a large Dutch bank with the identification of ESG risk factors that have a material impact on the credit risk profile of its portfolio of corporate loans. The material risk factors are then integrated in the bank’s existing credit risk framework to ensure a proper management of this new risk type.

We are supporting other banking clients with the quantification of climate change risk. In one case, we are determining climate change risk-adjusted Probabilities of Default (PDs). Using expected future emissions and carbon prices based on the climate change scenarios of the Network for Greening the Financial System (NGFS), company specific shocks based on carbon prices and country specific shocks on GDP level are determined. These shocked levels are then used to determine the impact on the forecasted PDs. In another case, we are investigating the potential impact of floods and droughts on the collateral value of a portfolio of residential mortgage loans.

We also gained experience with the data challenges involved in the typical ESG project: e.g., we are supporting an asset manager with integrating and harmonizing ESG data from a range of vendors, which is underlying their internally developed ESG scores. We also support them with embedding these scores in the investment process.

With our extensive track record in financial and non-financial risk management at financial institutions in general, and our more recent ESG experience, Zanders stands ready to support you with the ambitious, yet rewarding challenge to adopt a climate change-resilient strategy and to integrate climate change risk in your existing risk frameworks.

Foot notes:

1 The IPCC Working Group II contribution: Climate Change 2022: Impacts, Adaptation and Vulnerability.
2 The IEA report, Net Zero by 2050.
3 See the Net Zero Financing roadmaps from the UN, ‘Race to Zero’ and the ‘Glasgow Financial Alliance for Net Zero’ (GFANZ).
4 Based on the statistics of the Bank for International Settlements (BIS) per 2021-Q3.
5 The Climate Bonds Initiative’s Sustainable Debt Highlights H1 2021.