04/22/2021 | Press release | Distributed by Public on 04/22/2021 13:34
Climate change is a major source of financial risks, and an increasing number of financial regulators and supervisors around the world are striving to incorporate these risks in the prudential agenda. But which are the options available to financial supervisory authorities?
Sound corporate governance arrangements are essential to the functioning of financial institutions and to the financial system more broadly. Effective corporate governance can also be instrumental to successfully manage climate-related risks, as highlighted by the Central Banks and Supervisors Network for Greening the Financial System (NGFS) in a recent report.
The Basel Committee on Banking Supervision plans to analyze how climate-related financial risks can be incorporated into the existing Basel Framework. But the existing international supervisory guidance-namely the Basel Committee's Core Principles for Effective Banking Supervision and the Corporate Governance Principles for Banks-already provides the framework in which banks and supervisors could take initial steps to achieve robust and transparent corporate governance arrangements as well as effective climate-risk management.
Two of these key steps should be highlighted:
First, supervisors could set out expectations regarding the board of directors' composition. In particular, supervisors could expect that banks' boards include members with experience on climate-related financial risks. International regulation emphasizes the linkage between board qualification and the ability to exert an effective oversight over banks' business. Depending on the banks' risk profile, the boards' collective suitability would benefit from expertise around the financial risks arising from climate change.
Supervisory authorities could expect that banks' boards understand the financial risks arising from climate change that affect the banks. In conducting the 'fit and proper' test, supervisors could assess experience on climate-related risks, which could be gained during previous occupations or academic assignments. To help board members acquire, maintain, and enhance their knowledge and skills-and fulfil their responsibilities-supervisors could expect that banks' boards of directors participate in induction programs and have access to ongoing training.
Second, supervisors could set out expectations regarding the board involvement in climate-related risks. Specifically, supervisors could expect that banks' boards of directors consider climate-related financial risks when approving the banks' strategy. This would ensure the long-term sustainability of the bank in the face of a changing climate and the transition toward a more sustainable economy.
Climate-related risks should also be considered by banks' board of directors when approving the bank's risk appetite framework. Since climate change might alter the aggregate level and types of risks that a bank is willing to accept or to avoid in order to achieve its business objectives, it appears appropriate that banks' risk appetite statements (i) identify sectors exclusion policies, (ii) take into account the results of stress tests on climate-related risks, and (iii) consider the uncertainties around the timing and the channels through which the climate-related financial risks may materialize.
In line with the Financial Stability Board's Principles for Sound Compensation Practices, supervisory authorities could expect that banks' remuneration policies and practices stimulate behavior consistent with managing climate-related financial risks. These would foster a long-term approach to managing these risks, with the variable remuneration component linked to the successful achievement of climate-related objectives.
In addition, supervisors might require banks' boards of directors to approve policies and procedures on climate-related financial risks and review them on an annual basis. Policies and procedures would embed climate change in the risk management metrics, the internal control framework, and the decision-making process.
Finally, supervisory authorities could expect that banks' boards exert adequate oversight over climate-related risks. Banks' boards might need to identify and allocate responsibility to a sufficiently senior representative within the organization, ensuring that adequate resources and sufficient skills and expertise are devoted to managing the financial risks from climate change in the relevant business lines.
In conclusion, prudential supervisors could take advantage of the existing international framework to set out expectations on banks' corporate governance and climate-related risks , signaling to the market their intention to raise the bar in tackling these emerging risks. This could go in parallel with strengthening banks' risk management practices and improving disclosure, which we will discuss in future blogs.
In line with its new Climate Change Action Plan for 2021-2025, the World Bank stands ready to assist member countries in developing a suitable legal and regulatory framework, focusing on achieving impacts within each country's overall climate adaptation strategies.
This is the first of a three-part blog series on how financial supervisors can help green the financial system. Part 2 will discuss risk management and Part 3 will focus on disclosure.