Last month Sustainable Finance Lab and the New Economics Foundation organised a virtual roundtable discussion on climate risk and prudential supervision. The goal of the discussion was to identify next steps in supervising these risks in the banking sector. Representatives from multiple central banks, academics and NGOs were present at the roundtable and shared their ideas.
The risks of a changing climate requires action
The urgency of addressing climate risk is clear. All participants of the webinar concluded that climate risks are large risks to the banking sector and they will likely materialise within 5 years. It was also recognised that both transition risks and physical risks are important to consider.
Dutch banks facing transition risks
The Dutch central bank (DNB) presented its recently conducted study on transition risks in credit portfolios of Dutch banks. The study identified the deviation of companies in the loan portfolios from the transition path required to meet the 1,5 degrees temperature increase using the PACTA methodology. They found that the companies in carbon-intensive sectors in bank’s loan portfolios are not transitioning quickly enough to meet the goals of the Paris Climate Agreement. This means it’s likely that banks will see large transition risks. In the report the DNB is advocating for a stronger treatment of climate risks in the prudential framework and is in favour of setting concentration limits.
In the discussion several elements were identified that also deserve to be looked at, such as physical risks and their interrelations with transition risks and households.
Is the Pillar II capital framework sufficient?
When it comes to translating climate risks into capital requirements most of the action is around pillar II. The European Central Bank (ECB) has put supervisory expectations on climate and environmental risks on the table. However, the ECB concludes that banks are still underestimating these risks and more action is needed. The ECB has now set a deadline for banks to meet all supervisory expectations by 2024. And they will likely set Pillar II capital add-ons as part of the Supervisory Review and Evaluation Process (SREP) for the worst performers. However, several questions about this approach were brought up. For example, how large these add-ons will be and how they are calibrated. And are these for banks that don’t consider climate risks at all or also for banks who underestimate their climate risks? Also, is forward looking information sufficiently taken into account as the current prudential framework is mostly backward looking? And how to deal with the radical uncertainty (for example on tipping points) climate change brings? Is the Pillar II capital regime sufficient to integrate climate risks or are additional prudential approaches needed?
Other supervisory approaches on the table
There are different options for integrating climate risks into the prudential framework. These are helpfully laid out in a paper written by Maria Nikolaidi and Yannis Dafermos, which was also presented. Microprudential approaches focus on the institution’s climate risks with the main goal to make sure that institutions hold enough capital against these risks. Integrating climate risks in Pillar II is an example of a microprudential approach. Additionally integrating climate risks in the Pillar I framework could be considered. Macroprudential approaches aim to address systemic risks; the risks to which all financial institutions are exposed and which are amplified through spillover effects and interlinkages between them. Examples of macroprudential approaches are concentration limits, a systemic climate risk buffer or a counter-cyclical buffer. The participants pointed out that efforts should not be focused on one tool specifically, but that several of them should be on the table, including other measures than capital requirements only.
The role of central banks and supervisors
It has been argued that prudential policy should be risk based and that a ‘promotional’ role for central bankers and supervisors to support the transition is not within their mandate. However, supporting the transition by prudential policy could reduce systemic risk in the future and could therefore be considered as risk-based. Therefore, prudential policy needs to focus both on a robust financial system, but also on reducing emissions and facilitating the transition (double materiality concept).
During the round table we explored different microprudential and macroprudential approaches; each with their own challenges, goals and benefits. It was clear from the discussion there was an interest in understanding these approaches better and to do further research. There seemed to be most appetite to further explore macroprudential approaches.