GSE RISK: THE BASEL COMMITTEE PROPOSES TREATMENT OF CLIMATE RISKS IN PILLAR 1

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1.  The Basel Committee’s approach to integrating climate risk into Pillar 1

The Basel Committee has examined the extent to which climate risks can be addressed within the Basel framework. This involves identifying potential gaps in the current framework and analysing possible measures to address them. Thus, in 2021, the Basel Committee published analytical reports that conclude that climate risk factors can be accommodated within traditional financial risk categories. The Basel Committee also published a report in 2022 on “Principles for effective management and supervision of climate-related financial risks”.

According to these Basel Committee reports, banks must :

  • Integrate climate-related financial risks into their interpretation and application of the existing Basel framework.
  • Continuously develop their capacity and expertise in climate-related financial risks.

In its December 2022 report, the Basel Committee provides answers to the FAQs in order to :

  • Clarify how climate-related financial risks can be taken into account in the existing Pillar 1.
  • Facilitate consistent interpretation of existing standards in light of the unique characteristics of climate-related financial risks while not changing existing standards.
  • Allow flexibility while encouraging banks to develop their measurement and mitigation of climate-related financial risks.
  • Promote consistent implementation of the Basel Framework globally.
  • Facilitate the implementation of the existing Basel framework, in particular due to the availability of sufficiently granular data and consistent measurement methodologies for climate-related financial risks as they are improving over time.

2.  Integration of climate risk into the prudential framework for credit risk

2.1.   consideration of climate risk in due diligence on the creditworthiness of counterparties

Climate-related financial risks can affect banks’ credit risk exposure through their counterparties. Thus banks should :

  • Give due consideration to climate-related financial risks as part of the counterparty’s due diligence.
  • Integrate climate-related financial risks either in their internal credit risk ratings or when performing due diligence on external ratings.

2.2.   consideration of climate risk in due diligence on exposures to COVERED bonds and their issuing banks

Climate-related financial risks can impact banks’ exposure through the creditworthiness of the covered bond and the issuing bank. To the extent that the creditworthiness of the covered bond and the issuing bank is affected by climate-related financial risks, banks should :

  • Give due consideration to the financial aspects of climate-related risks as part of due diligence.
  • Integrate climate-related financial risks, either in their internal credit risk rating or during due diligence on external ratings.

2.3.   inclusion of climate risk in the Standardised Approach to Assess Credit Risk on Banking Counterparties (SCRA (finalization of Basel 3)

Banks must :

  • Consider the impact of significant climate-related financial risks on the bank counterparty’s ability to meet its financial commitments in a timely manner over the expected life of the exposures to that bank counterparty.
  • Prudently assess the bank counterparty’s ability to repay its commitments by taking into account significant climate-related financial risks throughout the credit life cycle
  • Include customer due diligence as part of the on-boarding process and ongoing monitoring of customer risk profiles

2.4.   consideration of climate risk in the assessment of investment grade corporate exposures

When determining whether a particular company meets the definition of investment grade, banks should :

  • Consider and assess how significant climate-related financial risks could affect the company’s ability to meet its financial commitments in a timely manner, even in the face of adverse changes in the economic cycle and business environment.
  • Rely on a systematic credit review process to determine at an early stage whether the credit quality of the company has declined to the point where it no longer meets the definition of investment grade.
  • Continue to assess the impact of climate-related financial risks as the capacity to assess climate-related financial risk data improves.

2.5.   consideration of climate risk in the determination of high-quality specialised lending (finalisation of Basel 3)

Changes in environmental policy, technological progress or investor sentiment may expose projects to transition risks. At the same time, projects may be exposed to physical risks depending on their type and location.

Thus, when assessing the ability of a specialized lending entity to meet its financial commitments in a timely manner, banks should :

  • Examine the extent to which climate-related financial risks may adversely affect a project finance entity’s ability to meet its financial commitments in a timely manner.
  • Continuously assess the impact of climate-related financial risks as the quality of climate data improves.

2.6.   consideration of climate risk in the prudential treatment of real estate

In assessing whether risk weights are too low, national competent authorities should take into account climate-related financial risks, including the potential effects on damages or losses in value arising from climate-related financial risks:

  • Weather-related risks.
  • Implementation of climate policy standards.
  • Changes in investment patterns resulting from transition policies.
  • Changes in consumption patterns resulting from transition policies.

Banks should consider whether the current market value incorporates potential changes in property values arising from climate-related financial risks:

  • Potential damage due to weather hazards.
  • Implementation of climate policy standards.
  • Changes in investment patterns resulting from transition policies Changes in consumption patterns resulting from transition policies

2.7.   consideration of climate risk in the irb approach to specialised lending (supervisory slotting criteria)

When assessing the component category of sub-factors, banks should :

  • Analyse how climate-related financial risks could negatively impact on category allocation.
  • Include any potential impact on financial strength:
    • Estimates of future demand.
    • The economic hypothesis.
    • The stressed economic conditions used for the stress analysis.
    • The political and legal environment :
      • Risk of transition to “stability of the legal and regulatory environment (risk of change of law)”).
      • Physical risk as “force majeure risk (war, civil unrest, etc.)”.
      • The characteristic of the asset in the case of object financing.
    • Consider whether climate-related financial risks have been adequately mitigated.
    • Improving adaptation to physical climate risks.
    • Take out insurance against physical weather risks.

2.8.   consideration of CLIMATE RISK IN THE RATING CRITERIA

When assigning ratings to borrowers and facilities, banks should :

  • Consider important and relevant information on the impact of climate-related financial risks on the characteristic borrower’s financial position and credit facilities.
  • Consider the physical and transitional risks to which the borrower is exposed and the measures taken by the borrower to mitigate these risks.
  • Establish an effective process for obtaining and updating relevant and meaningful climate-related information on the financial condition and characteristics of borrowers’ facilities, as part of the on-boarding process and ongoing monitoring of borrowers’ risk profiles.
  • Consider whether it would be appropriate to adopt a more conservative approach to the allocation of exposures to categories or pools of borrowers and facilities in the application of the rating model.
  • Rely to some extent on the conservative application of expert judgement for the purposes of rating.

2.9.   CONSIDERATION OF CLIMATE RISK in the Rating Horizons

Banks must :

  • Use a time horizon longer than one year to assign ratings.
  • Include financial climate risks, both physical and transitional, if they materialise as credit risks.
  • Assess the granularity of data relevant to climate-related financial risks that should be collected (e.g. counterparty location data).

2.10.     consideration of CLIMATE RISK IN THE RESISTANCE TESTS USED FOR THE ICAAP

Climate-related financial risks are likely to affect banks’ credit exposures and banks’ assessment of credit risk, asset impairment and expected credit losses.

Banks should consider climate-related financial risks that affect the range of possible future economic conditions in their stress testing processes in an iterative and progressive manner. A bank using the internal model approach should consider climate-related financial risks that may have a material impact on the bank’s credit exposures over the assessment period.

2.11.     consideration of CLIMATE RISK IN THE GLOBAL ASSESSMENT NEEDS (structure and intent)

In estimating PD, LGD and EAD, challenges include the range of impact uncertainties, limitations in the availability and relevance of historical data describing the relationship between climate risk factors and traditional financial risks, and time horizon issues. Where a bank’s credit portfolio is materially exposed to climate-related financial risks, it should:

  • Focus on factoring these risks directly into its estimates.
  • Make adjustments for technical and information limitations when estimating risk parameters.
  • Assess the implications of new data and the relevance of the data not only to current data, but also to foreseeable market and economic conditions.
  • Add a margin of conservatism due to data gaps, such as poor data quality or scarcity of climate-related data, and other sources of additional uncertainty.

2.12.     ACKNOWLEDGING CLIMATE RISK IN the Specific Requirements for Estimating LGD: Corporate, Sovereign and Bank Exposures

Where banks link their internal ratings to a scale used by an external credit assessment institution, they must :

  • Determine whether the scale used by the external institution reflects significant climate-related financial risks.
  • Critically review the models and methods used by the external institution where the scale used by the external institution takes into account significant climate-related financial risks.
  • Determine whether adjustments are appropriate to mitigate this limitation when the scale used by the external institution does not incorporate climate consideration.

The credit assessment will evaluate climate-related financial risks given the challenges of data sources, data granularity and historical time series that often apply to climate-related financial data risks.

2.13.     Specific requirements for LGD estimates: standards for all asset classes

When assigning ratings to facilities, banks should :

  • Consider important and relevant information on the impact of climate-related financial risks on the characteristics of facilities.
  • Establish an effective process for obtaining and updating relevant and meaningful climate-related information on the characteristics of the facility.
  • Consider whether it would be appropriate to take a more conservative approach in assigning exposures to facility classes or pools in the application of the rating model where the bank believes that an exposure is materially exposed to climate-related financial risks, but does not have sufficient information to estimate the climate risk
  • Rely to some extent on a prudent application of expert judgement in assigning ratings to historical exposure categories and not just on the estimated market value of the collateral.

In estimating the LGD-in-default, challenges include the range of impact uncertainties, limitations in the availability and adequacy of historical data describing the relationship between climate risk factors and traditional factors, financial risks and time horizon issues.

Where a bank’s credit portfolio is materially exposed to climate-related financial risks, it should :

  • Factor these risks directly into your estimates.
  • Make adjustments for technical and information limitations when estimating risk parameters
  • Assess the implications of new data relevant not only to current conditions but also to foreseeable economic and market conditions
  • Add a margin of conservatism due to data gaps, such as poor data quality or scarcity of climate-related data, and other sources of additional uncertainty.

3.  Integration of climate risk into the prudential framework for market risk

Banks must :

  • Consider climate-related risk factors in their stress testing programme to assess the potential impact on market risk positions, including the impact of a sudden shock on the value of financial instruments, correlations between risk factors, and the pricing and availability of hedges.
  • Incorporate significant financial climate risks in an iterative and progressive manner into stress testing programmes and internal capital assessment processes (ICAAP) as methodologies and data used to analyse these risks mature over time and analytical gaps are filled

4.  Integration of climate risk into the prudential framework for operational risk

Climate risks can impact the different categories of operational risks:

  • Losses due to natural disasters correspond to the event type category “Damage to property”.
  • Climate-related financial risks can also lead to operational risk losses in other event categories. For example, if a bank is perceived to misrepresent the sustainability practices or sustainability features of its investment products, this could lead to litigation (event type category “Customers, products and business practices”).
  • A power outage resulting from weather-related financial risks could lead to a disruption of a bank’s services and communications (event type category “Business disruption and system failures”).

Wherever possible, losses whose root cause could be climate-related risk factors should be identifiable from the loss database, for example by using a special flag.

5.  Integration of climate risk into the prudential framework for liquidity risk

Banks must :

  • Consider significant financial climate risks in their internal liquidity stress tests to assess their potential impact on net cash outflows or the value of liquidity reserve assets.
  • Use these assessments to inform the level of liquidity they should hold above the LCR minimum.
  • Integrate significant climate-related financial risks into ILAAP’s internal processes in an iterative and progressive manner as the methodologies and data used to analyse these risks evolve over time and analytical gaps are filled

Supervisory authorities must :

  • Take into account significant financial climate risks among other considerations when determining a response to a bank’s use of its HQLA stock.
  • Take into account climate-related financial risks that may affect current and forward-looking assessments of macroeconomic and financial conditions that would be relevant to address a reported LCR below 100%.

6.  References

Basel Committee on Banking Supervision: Frequently asked questions on climate-related financial risks.