This week both the Basel Committee on Banking Supervision (BCBS) and the Office of the Comptroller of the Currency (OCC) will be accepting feedback from stakeholders on recently proposed principles for the management and supervision of climate-related financial risks. The eight U.S. global systemically important banks – all Forum members — are deeply engaged in this topic and have provided feedback through the Forum on both the BCBS and OCC proposals. These firms are required to have extremely robust risk management frameworks that account for all material risks. The official sector’s new and recent focus on climate-related financial risks presents an important opportunity to establish durable and effective guidance from reasonable first principles that fit within the scope of existing risk management practices. Accordingly, we think it is important and helpful to lay out a few key principles that will promote final principles on climate-related financial risks that is efficient, effective, and well-integrated with existing risk management frameworks.
Climate principles should be risk-based and flexible. The Forum supports high-level principles that enable banks to flexibly incorporate climate-related financial risks into their existing risk management frameworks. Large banks, by necessity, are devoted to ongoing and holistic risk management. It is crucial that new or evolving risks be managed within the existing framework to ensure that risk management is effective and efficient. Building a new and untested set of processes for each and every new risk that comes to light would result in an overwrought system ill-suited to its task, and could lead to insufficient management of the most significant risks. In addition, we support a risk-based approach that considers the unique characteristics of each bank and allows banks to focus on targeting material climate-related financial risks, which are likely to vary significantly across the banking sector.
Climate principles should use scenario analysis rather than traditional stress testing or capital charges. The Forum supports the use of scenario analysis to explore the potential impact of climate-related financial risks. Scenario analysis should focus on material exposures and incorporate plausible climate scenarios. Scenario analysis should be clearly distinguished from traditional stress tests or capital charges. As we have discussed previously, the time horizon over which climate-related risks may materialize is likely far longer than that required for capital planning. Additionally, the state of knowledge on climate-related risk assessment is in its earliest stages. The nascent state of our understanding, as well as important limitations in both climate data and modeling would make any capital requirements premature – a sentiment shared by Treasury Secretary Janet Yellen. Scenario analysis, however, can be used flexibly to continually assess climate-related risk exposures and can improve over time as data, methods, and our understanding of climate-related financial risks improve.
Scenario analysis should make use of time horizons that align with broader risk management goals. The time horizon employed for scenario analysis is a key parameter that determines its usefulness for risk management. The time horizon used in scenario analysis should be consistent with current approaches to risk management in order to facilitate incorporating climate-related financial risks into existing practices. Moreover, while it may be sensible to consider climate-related financial risks over a somewhat longer time horizon, extraordinarily long horizons, such as 30 years, that do not relate to ongoing risk management or business planning would not support effective and holistic risk management.
Scenarios should be plausible. Climate scenarios may be severe and rigorous but should also be credible. Scenarios keyed to tail risks that are too remote may result in risk measurements that are not highly relevant or actionable. Overall, the degree of severity in any climate scenario must be appropriately balanced against its plausibility. This balance should be made explicit in a well-articulated and measurable standard to ensure that climate scenarios, and in particular transition risk scenarios, are empirically relevant and have the potential to result in actionable outcomes. Transition risks are inherently more difficult to assess because they often depend on the path of government policy and different assumptions about the specific type and trajectory of policy can lead to widely varying outcomes. Transition risks may also incorporate market, technology and innovation risks further complicating its analysis. Accordingly, transition risk scenarios should be clear, comprehensive and credible.
Climate principles should take a phased approach. Unlike traditional financial risks such as credit risk or interest rate risk, climate-related financial risks are not well-established or understood. The data, models, and methods for assessing these risks are emerging rapidly. Accordingly, regulators should establish principles that aim to be “future proof” by explicitly allowing for growth and innovation and guard against getting locked into approaches that are viable in the present but will soon be outmoded.
The Forum and its members welcome the public dialogue on climate-related financial risks and we look forward to increased engagement as other regulators engage on this issue. As we move forward on assessing the importance of climate-related financial risks and appropriate risk management practices we should endeavor to ensure that expectations of banks fit within a broader risk management framework, address plausible scenarios and remain distinct from near-term capital requirements.