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Climate risk: strong Pillar II prudential measures are needed but not enough

A detailed look at ongoing prudential initiatives under Pillar II shows that they are needed, but reveals their intrinsic limitations and suggests the need for stronger prudential measures.

N.B.: This text features extracts from the Finance Watch report “A silver bullet against green swans”

Leading regulators, supervisors and researchers from around the world have long recognised the financial stability implications of climate change and the financial nature of climate-related risks.  Financial stability is at risk, as climate change-related extreme events will disrupt our ecosystems, infrastructures, supply chains, impact human health and mortality. These events will, in turn, lead to massive and abrupt devaluations of assets and collateral held by financial institutions, unexpected price swings and market movements affecting the whole spectrum of financial risks across our financial system.

Climate-related financial risks have specific features, which pose significant challenges when it comes to deploying existing prudential tools and approaches to tackle them. Specifically:

Disruption risk: Climate-related events are defined as “green swans” and have specific features, which makes them impossible to predict and model. In particular, green swans are characterised by: i) certainty of their occurrence despite highly uncertain impacts and the impossibility to determine the exact timing of their materialisation; ii) wide-ranging and existential impacts on the economy and the financial system; iii) a high degree of complexity, including cascade effects and chain reactions in the environment, economy and society.

Probabilities of climate-related events not reflected in past data: Traditional risk modelling based on historical data is not possible as we are dealing with a forward-looking phenomenon, for which no past data can be used reliably to extrapolate the future. By definition, when the data eventually arrives, it will be too late to avert a global climate change-induced financial crisis.

Growing risk with prolonged inaction: The magnitude and probability of climate change materialisation are increasing as long as no tangible actions are taken to reduce greenhouse gas emissions. Once global temperatures have exceeded their pre-industrial level by 2°C, the consequences on human society and the global economy will be irreversible and largely unpredictable.

The time horizon of climate-related financial risks materialisation can be significantly longer than the horizon of the current business forecasting, planning and risk management frameworks. This poses additional challenges for financial institutions to appropriately incorporate CRFR into their management practices.

Environmental stability, including climate, is by nature a public good, which comes at no cost to private agents. Coupled with the long materialisation horizons of climate-related financial risks, this means that businesses and financial institutions do not have incentives to consider the implications of their activities for the environment/climate. Looking after public good is the mission of governments/regulators, not private agents.

The role of prudential policy is to ensure that climate-related financial risks are identified and appropriately managed by financial institutions. In this respect, views on the most appropriate prudential measures are widely divergent. Different prudential solutions exist to incorporate CRFR into the existing prudential frameworks and  in particular into risk management processes. Pillar II measures have been the focus of this debate lately and this article looks into their role.

Breakdown of possible Pillar II  measures to manage CRFR

Under Pillar II, banks and insurance companies are obliged to establish risk management processes and assess the adequacy of their capital to cover all the risks they can potentially face in the course of their business, which includes solvency. Supervisory authorities then conduct their review and assess institutions’ risk profiles from four different angles: (i) business model, (ii) governance and risk management, (iii) capital and (iv) liquidity. Based on this assessment, institutions are required to maintain additional capital (Pillar II add-on) for risks that are not covered by minimum regulatory capital requirements under Pillar I.

1 Financial institutions’ risk management and capital assessment processes

Advocates of Pillar II prudential measures as a tool to address CRFR argue that financial institutions are best placed to assess and manage their risks, including CRFR. According to them, this can be achieved specifically via[1]:

  • Assessing CRFR at exposure/borrower level when taking financing decisions.
  • Considering CRFR in the internal risk and capital/solvency assessment process.
  • Aligning the institution’s portfolio with the Paris Agreement, such as 2050 net-zero emissions (net-zero alignment).

Whilst Pillar II measures are an important element of the institutions´ own risk management process,  significant challenges need to be resolved before these measures can lead to effective and impactful outcomes in managing CRFR, which means that the measures are unlikely to come in time to prevent major CRFR from materialising.

There are a number of key factors that support this assessment:

  • No credible methodologies or tools have been developed yet to accurately identify and assess/measure CRFR. In April 2021 the Basel Committee on Banking Supervision (BCBS) published two reports outlining numerous challenges and conceptual issues in this respect. The most notable of these include the specific features of CRFR, data gaps, difficulties to translate climate-related events into financial impacts on institutions’ portfolios (climate risk drivers and transmission channels).
  • None of the Pillar II measures have yet led to additional supervisory capital requirements being imposed on financial institutions ensure their resilience against CRFR. In 2020, most of the supervisors within the NGFS were “of the opinion that it is too early for imposing Pillar II capital requirements”, this is due to the challenges in quantifying CRFR mentioned above, among other reasons.
  • By design, models and approaches used for Pillar II risk and capital adequacy assessment are largely at the discretion of each institution and not subject to the same level of supervisory scrutiny as the models for regulatory minimum capital requirements (Pillar I). Given the challenges to measure CRFR, Pillar II approaches are likely to result in heterogeneous outcomes rather than provide for a consistent approach to managing CRFR across the financial system.
  • Net-zero alignment is also far from being a reliable tool to manage CRFR: A lot of work needs to be done on data gaps, methodologies and metrics to ensure net-zero commitments are effective and credible. Different studies indicate that existing methodologies are incomplete and incomparable, which increases the risk of greenwashing. The present debate on net-zero alignment highlights a need for regulatory standards before alignment plans can be treated as a truly credible and science-based risk management tool. Net-zero targets also need to be supported by credible monitoring and enforcement mechanisms. The limits of the current voluntary commitments against the growing volumes of fossil fuel financing were highlighted in a number of recent reports. Finally, and most importantly, by accounting for the impact of financial institutions on the climate (inside-out materiality), the alignment method disregards the physical impact of climate change on financial institutions (outside-in financial materiality). For example, planting trees will not hedge a specific financial institution from its stranded assets risk.

2 Supervisory “stress tests”

The world’s leading supervisors put a lot of value on climate “stress tests” as a tool to identify and manage CRFR across the financial system. Indeed, the results of such exercises offer valuable insights into the climate-risks of financial institutions and potential channels and effects where they materialise. These insights help shape supervisors’ actions and also raise awareness among financial institutions to enhance their risk management practices and adapt business models. However, there are significant limitations to the so-called “stress tests”, some of which had been highlighted in Finance Watch’s report “Breaking the climate-finance doom loop”. Despite the progress made on supervisory stress tests since then, certain important challenges remain:

  • The majority of “stress test” exercises have focused on transition risks and largely failed to address the physical risks induced by climate change. Recent attempts to incorporate physical risks were limited in scope and encountered significant practical challenges.
  • “Stress tests” ignore the disruption risk dimension, which results from the unpredictable and non-linear nature of climate-related events, and from the interconnections among natural systems that can amplify climate impacts, which together make modelling climate risks with any degree of precision impossible.
  • “Stress tests” have not yet led to, and were not even intended to lead to, conclusions about the capital adequacy of tested financial institutions. While the ECB recently indicated that this might change for its supervised institutions, implementation will be years away.
  • Transmission channels between climate events and financial implications for the balance sheets/capital of affected institutions require further exploration before they are fully understood.
  • The existing scenarios do not take into account the feedback loop, i.e. the impact which the financial sector itself has on transition and climate developments. There can be scenarios where the financial system plays a hampering role in the transition, meaning that the resulting impacts of scenarios (risks) might be underestimated.

The ECB has made progress in overcoming some of those challenges in its EU-wide stress test exercise, however the ECB also outlined that a significant amount of work is yet to be undertaken towards “a comprehensive climate stress-testing framework”.

3 Governance and business strategies

Governance and business strategies are overarching components of the prudential toolkit in the context of Pillar II. By embedding CRFR and wider sustainability risk considerations into corporate governance and business strategies of financial institutions, prudential rules can help account for the public good nature of the climate/environment, overcome short-termism in the management of risks and align commercial goals with objectives of environmental preservation. In fact, in order to implement the risk management tools outlined above, financial institutions need to start by defining corresponding business strategies and establishing appropriate governance arrangements such as managing bodies, internal controls and remuneration systems, which support the objectives. Business strategies and governance should be considered in conjunction with other prudential measures and not as stand-alone tools to manage CRFR.

Conclusion on Pillar II measures

Pillar II prudential tools are intended to ensure that financial institutions develop and use risk management techniques when monitoring and managing the risks of their business. Whilst substantial  work on Pillar II measures to address CRFR is currently being done, significant challenges remain in developing reliable, science-based, comparable risk identification and measurement methodologies. Climate-related commitments need to be supported by clear milestones and a monitoring processes. None of the measures have yielded tangible results yet.

In 2021, the ECB assessment of banks’ current progress on Pillar II measures,  concluded that banks’ current practices fall short of supervisory expectations[2]. Moreover, in March 2022, ECB concluded that the supervised banks did not even meet the supervisory expectations on disclosure of climate and environmental risks. Meanwhile, ECB confirmed the clear benefits of acting early, as CRFRs grow when inaction lingers. CRFRs remain completely unaccounted for by capital requirements (Pillar I) despite the fact that they constitute the main building block to ensure the resilience of financial institutions. Further work on Pillar II measures is important, as some of the limitations of Pillar II instruments that are described above might be resolved in the future. But even then, the limitations related to the specific characteristics of “green swan” events will remain, leaving financial institutions exposed.

In the meantime, Pillar I is important as it is the key instrument  to ensure the resilience of the financial sector and its ability to support the economy in the future. The financial crisis of 2008 remains a close-enough reminder. Focus on other “softer” prudential measures carries the risk of missing a critical time point for impactful action while concentrating on complacent exploration of options, which will neither be timely nor effective enough in tackling the financial stability risk induced by climate change.

Julia Symon

Footnotes:

[1] The EBA refers to the approaches below as exposure, risk framework and alignment method correspondingly, cf. the EBA Report on management and supervision of ESG risks for credit institutions and investment firms, 23 June 2021.

[2] ECB, The clock is ticking for banks to manage climate and environmental risks, Supervision Newsletter, 18 August 2021.

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