Reflections on the Basel Committee’s climate risk principles

November 18, 2021

Are they a good blueprint for action on climate-related financial risk management, or a paper tiger?

Empty chairs arranged in a circle in a dark studio room

The compromise deal reached at COP26 in Glasgow on Saturday may have dominated the headlines this week, but bankers have likely been far more absorbed by the output of another small group of policymakers on the other side of Europe.

On Tuesday, the Basel Committee on Banking Supervision (BCBS) — a panel of global regulators — published ‘Principles for the effective management and supervision of climate-related financial risks’ for public consultation. The document represents the Committee’s first major foray into the fast-moving debate on how banks and their supervisors should tackle climate change threats, though it comes a little late — many financial authorities are already hard at work putting their own climate plans into action.

However, because of the BCBS’ cachet, what it has to say on the topic matters. The Committee is made up of 45 central banks and supervisors from 28 jurisdictions — and though members like the European Central Bank and the UK’s Prudential Regulation Authority may be ahead of the game when it come to climate risk, plenty of others are just getting to grips with the subject. The principles, then, could function as a roadmap for these members going forwards, and in doing so fundamentally shape global approaches to bank climate risk management.

This may concern ‘climate hawks’ — those who want authorities to introduce tough climate-related financial regulations. Why? Because the 18 principles — 12 for banks, six for supervisors — are fairly high level, and have nothing to say on curbing banks’ financing of the fossil fuel industry, which is, after all, the number one contributor to the very climate risks that threaten the financial system (along with every other system). 

Here’s what Julia Symon, Senior Research and Advocacy Officer at Finance Watch, a European think tank, told Climate Risk Review:

“All the principles speak about identifying and understanding the risks, trying to measure them, to monitor, to mitigate them, but they never talk about what supervisors should do once they find those risks. So they don’t go into the consequences. If we want immediate impact, we need other measures, like capital requirements”

Then there are the principles’ preoccupation with climate scenario analysis. ‘Scenario’ is mentioned 30 times in the BCBS document, and three of the 18 principles reference climate scenario analysis explicitly. True, climate scenario analysis should help institutions map climate risks and understand how they could upset the financial system. However, an inordinate focus on this tool threatens “paralysis by analysis”. Institutions may end up spending too much time conducting ‘what if?’ simulations and climate stress tests and too little working on measures to actually tackle emerging physical and transition risks. 

The BCBS principles also conceive of scenario analysis very broadly. Principle 18 says supervisors should “consider using climate-related risk scenario analysis, including stress testing” as part of their climate risk management programs, but then lists four different objectives such analyses could have — from “exploring the impact of climate change … on supervised banks’ strategies” to “informing the adequacy of supervised banks’ risk management frameworks, including their risk mitigation options”. Principle 18 also says the supervisory scenarios used should “incorporate a range of plausible climate pathways” and “consider a range of time horizons, from short- to long-term”. 

Again, on the face of it, this sounds sensible. Climate change could unfold in many different ways, and the low-carbon transition could take a variety of forms. It is also true that some climate risks, particularly transition risks, could crystallize abruptly over the next few years, whereas chronic physical risks may unfurl over decades. However, by endorsing an eclectic, wide-ranging approach to scenario analysis, the BCBS risks nudging supervisors to produce lots of information but little action. As Mark Cliffe wrote in a recent edition of Environmental Affairs:

“Attempts to produce detailed quantification down from a country and sector level to a local and business level on a multi-decade basis are liable to descend into a “number theatre” of colossal databases of useless data”

The principles also have little to say on what should happen in the aftermath of climate scenario analyses. Here’s how Symon at Finance Watch described it:

“They do mention that supervisors can potentially do follow up actions [after climate scenario analysis], but they never speak about what follow up actions. In a normal financial stress test, the bank would be asked: do you have a capital shortfall or not? And then: do you need additional prudential capital requirements or not?”

Such questions are not spelled out in the BCBS document.

Other principles may fail to spur effective action on climate risk management because of how they’re framed. The BCBS has in most cases chosen to draft the principles so that they fit with ‘traditional’ bank risk management practices. For example, Principle 5 says “banks should identify and quantify climate-related financial risks and incorporate those assessed as material over relevant time horizons into their internal capital and liquidity adequacy assessment processes”. However, the accompanying guidance says banks should “evaluate the solvency impact of climate-related financial risks that may manifest within their capital planning horizons” [emphasis added]. Most banks’ capital planning horizons span three to five years. This is too short a span to capture many climate risks, which are likely to manifest over a much longer time scale.

Certain supervisors have broken free of the limitations posed by such old school risk management practices. The European Banking Authority, for instance, has said banks should use at least a 10-year horizon for “strategic planning”. True, incorporating a decade-long projection into capital and liquidity assessments may be tricky, but it’s important for managing those climate “tipping points” that could cause big problems for banks down the line. Consider that by 2030, countries need to have cut carbon by 45% relative to 2010 levels to stay on a 1.5°C warming pathway. The actions taken to get there should trigger profound changes in the global economy, though many won’t be felt until after 2025 — when many banks’ current planning horizons end.

While climate hawks have plenty to grumble about, the principles are shot through with ideas that could, in the hands of forward-thinking banks and regulators, bring about important changes in how they deal with climate risks.

For one, there are the references to how banks should test for the materiality of climate risks to their businesses. Some firms may run an analysis today of how climate change could impact them and conclude that the risks aren’t material. But repeating the exercise one or two years down the line may produce very different results. Principle 14 says supervisors should “review the extent to which banks regularly assess the materiality of climate-related financial risks”. Some may interpret this as a license to compel firms to run frequent sweeps of the climate risk landscape. 

This may help banks stay on top of emerging threats. But Lauren Anderson, Associate General Counsel at the Bank Policy Institute (BPI), a bank lobby group, told Climate Risk Review that there’s lots of room for interpretation:

“It was interesting because they didn’t define [materiality] anywhere. Not even in a general context. They just left it. So materiality is going to mean one thing to one supervisor and one thing to another and something totally different to banks for sure. So I think there’s a question as to what the expectations really are there”

Some of the principles also include good, practical ideas on managing climate risks, especially climate-related credit risks. Principle 8, for instance, says that banks should “identify, measure, evaluate, monitor, report and manage the concentrations within and between risk types associated with climate-related financial risks”. This highlighting of concentration risks is significant, and could open the door to supervisors recommending or imposing exposure limits for certain climate-vulnerable credits.

Also in Principle 8, the BCBS says banks should consider handling climate-related credit risks by adjusting credit underwriting criteria, engaging with clients, or even “imposing loan limitations or restrictions such as shorter-tenor lending, lower loan-to-value limits or discounted asset valuations”. This principle should please climate hawks, as it could be deployed to support policies that place restrictions on climate-harming activities, like fossil fuel lending. 

Guidance fleshing out Principle 8 tells banks to consider setting limits on exposures “to companies, economic sectors, geographical regions, or segments of products and services that do not align with their business strategy or risk appetite”, which should similarly please climate activists. After all, those banks that have committed to net zero financed emissions by 2050 cannot credibly refuse to set limits on lending to fossil fuel companies that aren’t transitioning, or fund services that support existing fossil fuel infrastructure. Now activists can cite the BCBS principles as supporting evidence for their campaigns.

Still, the degree of influence the principles will have over banks and supervisors is yet to be determined. It may be that through the public consultation process, some of the principles are watered down. Even if they’re finalized in their current form, though, just how closely the BCBS will police their adoption by members remains to be seen. When it comes to the banking rules the BCBS issues, it runs a regular Regulatory Consistent Assessment Programme to monitor their implementation. However, principles aren’t the same as rules. It may be that the BCBS takes a different approach to their endorsement as a result. 

The Committee should feel some pressure to move the process forward, though, from the Financial Stability Board (FSB), another panel of global regulators (many of whom also sit on the BCBS). In July, the FSB published a roadmap for coordinating the multiple initiatives underway to tackle climate-related financial risks, with the objective of promoting “consistency of actions” across authorities and minimizing the risk of “harmful market fragmentation”. The BCBS is in a better position than most standard-setters to fulfill these two goals.

As the BPI’s Anderson explained:

“If you look at the FSB roadmap, they are clearly trying to have these principles developed — whether it’s through Basel or other standard-setters — so that they can then start to do peer reviews and assessment work in late 2022 to 2023. There’s a few missing steps in terms of whether these different bits of paper from the BCBS and elsewhere actually end up getting endorsed as standards, and have an assessment methodology developed for them for doing things like peer review. I don’t think we have all the details yet on how exactly that will shake out and of course some of this will be determined through political processes. So depending on where the world is in 6-12 months, those goalposts can shift”