Supervisory guidance on risk management can foster a greener financial sector

As more people see climate change as a source of financial risks, several financial supervisory authorities have started issuing risk management guidelines that incorporate climate-related risks, largely based on the Network for Greening the Financial System (NGFS)'s guide.

But the trend has been limited to advanced economies. Only a few emerging markets and developing economies (EMDEs) have begun making efforts to understand and assess climate-related financial risks.

Integrating climate-related financial risks into supervisory guidance could raise awareness and set expectations on how banks in EMDEs should integrate physical and transition risks in the overall risk management framework. It would foster the safety and soundness of banks and the banking system in these countries. In addition, by nudging banks toward greener investments, it would help mobilize the capital needed to support a post-pandemic green recovery.

While standard-setters such as the Basel Committee on Banking Supervision are expected to provide further international guidance, supervisors in EMDEs can already take initial steps to remedy the market failures caused by the lack of adequate incentives for banks to manage and mitigate climate-related risks.

These are some areas for action:

Advancing data collection and analysis: Embedding climate-risk drivers in the risk management process requires data aggregation capabilities. To help address deficiencies in the area, the NGFS has established a workstream on bridging data gaps. Supervisors in EMDEs could join the NGFS and, leveraging on its work, familiarize with international good practices, and engage in a dialogue with banks on how to model climate-related risks.

To challenge banks' models, prudential supervisors in EMDEs-which are often short of personnel skilled in quantitative analysis-can build up capacity through online training platforms and technical assistance. Regulatory technology (RegTech) solutions can be a useful tool, allowing big data analytics and machine learning to forecast and incorporate forward-looking information on climate risks.

Establishing a climate risk function: In line with the proportionality principle, supervisors could recommend to the larger and most-exposed banks that they consider establishing a climate risk function, which could report to the Chief Risk Officer. This would help provide a holistic perspective on how climate change affects the overall bank's risk profile.

This climate risk function could develop banks' climate-related financial risk policies and procedures, and integrate climate-related considerations in the credit risk assessment, while assessing and mitigating other risks-namely operational, market, and liquidity ones.

Integrating climate risks in the credit analysis: Supervisors could expect that climate-related risk drivers are integrated into the borrowers' creditworthiness analysis and influence contractual covenants and pricing, ensuring that the 'climate due diligence' is robust enough and influences the approval process.

Covenants related to compliance with environmental laws and/or adequate insurance in place-for floods or droughts, for example-could be considered as conditions for the disbursement of loans. Pricing could also reflect climate-related risks, with interest rates on long-term loans potentially linked to the borrowers' achievement of pre-agreed green goals.

Incorporating climate risks into capital adequacy: For those EMDEs that have implemented Basel II/III, supervisors could expect that the risk management considers climate-related risks as a part of the Internal Capital Adequacy Assessment Process (ICAAP). Banks could be expected to identify, at a minimum, exposures to sector highly vulnerable to transition and physical risks and consider approaches to manage them periodically.

Banks could be expected to demonstrate, subject to independent internal validation, the adequacy of the methodologies used to quantify the potential financial impact from climate-related risks. Forward-looking approaches, based on the analysis of prospective scenarios, could test banks' resilience to the potential materialization of physical and transition risks.

Models sold by third-party vendors should be expected to be fully understood by the banks before adoption, well-suited for, and tailored to their business context and risk profile. Should the exposures be material, banks could be expected to set up internal capital against climate-related financial risks.

Conducting stress tests: The risk management function of larger and complex banks could be expected to conduct internal climate change stress tests and/or scenario analysis. These would test the business model resilience and capital adequacy against a set of severe but plausible scenarios for both physical and transition risks, which could be based on those provided by the NGFS.

Banks could be expected to target key vulnerabilities and, should the results of internal stress tests lead banks below minimum prudential requirements, the risk management function could be expected to identify recovery options to restore business model viability.

Strengthening business continuity: Banks could be expected to strengthen business continuity management (BCM). The spatial location in which a bank operates might make it prone to certain physical risks. Banks need to be prepared for, and respond to, potential crisis situations that lead to disruptions.

Several BCM approaches have proven inadequate, primarily because they are focused on short timescales, while climate change is a long-term and dynamic phenomenon. Traditional recovery strategies might not be fit for the severity of natural disasters-for example, locations next to waterways, on the coast, or unsheltered from storms.

In sum, supervisory guidance can set out expectations, helping EMDE banks take climate risk management to the next level. In line with the new Climate Change Action Plan for 2021-2025, the World Bank stands ready to assist supervisors in client countries to upgrade their legal and regulatory framework.

Emma Dalhuijsen and Martijn Regelink contributed to this blog.

This is the second of a three-part blog series on how financial supervisors can help green the financial system. Part 1 discussed corporate governance and Part 3 will focus on disclosure. 

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