July 07, 2022
The Basel Committee on Banking Supervision recently released 18 principles that banks and their supervisors should consider when addressing the financial risks stemming from climate change. In recognition of climate risks threatening banking institutions and the broader financial sector, the Committee issued 12 principles for bank management and six principles for banking supervisors. In particular, the principles cover themes relating to corporate governance, internal controls, risk management, monitoring and reporting, and capital and liquidity.
As the global standard-setting body for internationally active banks, the Committee does not itself issue rules or regulations, but instead works with central banks and bodies to design common approaches relating to supervision. These climate-related principles, which the Committee expects member jurisdictions to implement “as soon as possible,” are the latest and broadest articulation of what global banking regulators should consider when seeking to address climate-related risks in an effective and coordinated manner.
The Committee issued 12 principles that banks should adopt to manage climate-related risks. These principles cover topics from corporate governance to scenario analysis.
The Committee recommends that banks adopt a process for assessing the impact of climate-related risk drivers on the bank, which includes understanding short- and long-term risks. Banks should consider how climate-related risk drivers might change the environments in which the banks operate. To ensure climate risks are not overlooked, a bank’s board and senior management should assign climate-related responsibilities to specific members or committees. Directors and senior management should be trained, including through internal workshops or with the support of outside experts.
Banks should incorporate policies and procedures that address climate-related risks throughout their organizations. In addition, a bank’s board and senior management should ensure that climate-related risks are clearly defined and addressed in the bank’s risk appetite framework. Banks should also “regularly” undertake a “comprehensive assessment” of climate-related risks and set clear definitions and thresholds for materiality.
Notably, banks should incorporate climate-related risks into their internal control frameworks across the three lines of defense. Under the first line of defense, staff should assess climate-related risks during client onboarding, credit application processes, and in ongoing monitoring and engagement with clients as well as in new product or business approval processes. In the second line of defense, the initial assessment should be reviewed and challenged by an independent group within the bank, while the compliance function should ensure adherence to applicable rules and regulations. The third line of defense requires an internal audit to assure the quality of the overall framework.
The Committee also directs banks to maintain sufficient capital given their climate-related risks. Among other things, banks should quantify their climate-related risks and incorporate those risks into internal capital assessment processes. Banks should consider these risks over multiple time horizons when calculating how much capital is required.
Banks should ensure their internal reporting systems are capable of monitoring climate-related risks, and banks’ risk data aggregation capabilities should account for these risks. Likewise, banks should consider how climate-related risks will impact different areas of their business, including credit risk profiles, market positions, liquidity risk profiles, and operational risk.
Finally, banks should use scenario analysis to determine the impact of climate-related risks on their business. Banks should also use scenario analysis to assess their climate-risk strategies. In addition, banks should assess whether climate-related risks could cause net cash outflows or depletion of liquidity buffers, assuming both business-as-usual and stressed conditions.
The Committee announced principles that supervisors of banks should adopt to oversee banks’ climate-related risk measures. In general, supervisors should ensure that banks follow the principles set out above. Thus, supervisors should assess that banks can identify and manage climate-related risks. Supervisors also should identify which board members or committees oversee climate-related risks and determine that banks have a framework in place throughout their organizations to protect against these risks, including the three lines of defense.
Likewise, supervisors should assess whether banks have adequately considered climate-related risks into their management of credit, market, liquidity, operational, and other types of risk. Supervisors should verify that banks’ boards and senior management receive accurate and appropriate internal reporting on material climate-related risks.
When overseeing banks, supervisors must be dynamic to ensure banks are adequately addressing these risks. Thus, supervisors should incorporate a range of techniques, including follow-up measures, establishing expectations, and sharing information with other supervisors. Similarly, supervisors must have adequate resources and expertise. The Committee also encourages supervisors to collaborate with the climate science community to stay informed on risks and to help develop best practices in scenario design for banks.
The Basel Committee’s release is the latest sign that global banking regulators are taking seriously the myriad of risks presented to the banking system by climate change. It also is an indicator of how climate change issues will be addressed by banking regulators, with a heavy emphasis on sound corporate governance and risk management tasks. For U.S. banks, many of the principles articulated by the Committee are not new. The OCC and the FDIC have recently proposed their own principles for the safe and sound management of exposures to climate-related financial risks. The Federal Reserve Board, for its part, has yet to do so, but it is highly likely that, when it does, many of the themes contained in the Committee’s release will be reflected in some way.
While the Committee’s principles do not have the force or weight of a rule or regulation, they should still be taken seriously. Banks may wish to review them in light of their own climate-related risk planning. Serious consideration should be given to areas of institutional weakness and whether outside experts and counsel may need to be engaged to help with “gap” assessment planning.
A special thanks to summer associate Patrick Nugent for his valuable contribution to this publication.