A prudent approach to climate risk

Introduction

The financial impact of climate change is widely recognised by supervisors and has motivated efforts to update the prudential framework. Regulators and supervisors alike have been focusing on scenario analysis and stress tests to assess the resilience of financial institutions in face of climate-related financial risks (CRFR).

However, this approach remains challenging and, hence, limited in its conclusions due to data gaps and modelling challenges. This paper argues that capital buffers offer a simpler, more immediate solution to mitigate CRFR while tailored approaches are being enhanced. This approach aligns with supervisors’ mandates on financial stability, and the precautionary principle recognised by the European Commission^[1] and the European Central Bank (ECB).^[2]

Moreover, climate change amplifies current financial risks at different levels and will require financial authorities to consider both institution-specific and systemic approaches. Macroprudential tools can be key in mitigating climate systemic risk by ensuring the resilience of the financial system against severe but plausible climate events.

 I. Overview of the current framework

Idiosyncratic risks are specific to the potential failure of a single institution, whereas systemic risks threaten the stability of the entire financial system, potentially triggering credit crunches, investment crises and economic downturns. Under the current prudential frameworks, management of idiosyncratic risks is a responsibility of banks themselves, as institutions are best positioned to understand the specifics of their operations and the associated risks. In contrast, overseeing systemic risks, which requires a comprehensive, system-wide perspective, falls under the purview of financial authorities.

The ECB identifies three primary forms of systemic risk^[3]:

• Contagion risk: the spread of instability from one institution to others
• Systemic shock: a simultaneous material shock impacting all institutions at once
• Minsky moment: the unravelling of long-standing imbalances within the system

Under the Basel III framework, risks are managed with several approaches: idiosyncratic risks are addressed with a microprudential (institution-specific) approach and systemic risks with a macroprudential approach (risk assessment by supervisors to account for system-wide weaknesses). In the European Union, this framework is implemented in the Capital Requirements Regulation (CRR) and the Capital Requirements Directive (CRD).

Banks are required to manage all material idiosyncratic risks they face. They must hold sufficient capital to cover unexpected losses (at a certain confidence level) arising from their activities. Under the current framework, policymakers require banks to capitalise 8% of their total Risk-Weighted Assets (RWA). RWA are determined by weighting a bank’s exposure to classic financial risks (credit, market, operational) depending on their respective riskiness. This baseline capital requirement (Pillar 1 capital under the Basel framework) is completed with the Internal Capital Adequacy Assessment Process (ICAAP) to address risks either insufficiently or not fully covered, providing a framework to capture more dynamic, forward-looking risks. While banks conduct internal risk assessments to quantify their capital requirement, supervisors evaluate the robustness of banks’ risk management under the Supervisory Review and Evaluation Process (SREP). If deficiencies are identified, supervisors may impose additional requirements, such as additional capital (P2R) or exposure restrictions, to ensure adequate risk mitigation.

For systemic risks, financial authorities monitor and analyse potential weaknesses that could trigger systemic failures. Based on this assessment, and if the risk is deemed to be unmanaged, they impose targeted capital or other measures on specific banks. At the international level, the Basel Committee has established a capital buffer framework comprising various buffers to mitigate possible systemic risks. This framework has been implemented and enhanced at the EU level under the CRD.

The CCoB is defined at EU level and applies uniformly to all EU banks. For other buffers, national supervisors, based on a quantitative assessment, can apply different rates to institutions in their own jurisdiction.

II. Managing climate-related idiosyncratic risks

The latest legislative package modifying EU prudential rules, known as CRR3/CRD6, has introduced dedicated requirements for banks to manage and disclose ESG risks. The European Banking Authority (EBA) has issued guidelines^[4] to specify the requirements and expectations for banks to manage their ESG risks, especially environmental ones. The EBA guidelines propose that banks include environmental scenario analysis and stress testing in their internal assessment framework (ICAAP), which supervisors then review under the SREP. While this forward-looking approach represents progress, it continues to face significant uncertainties and methodological challenges.^[5] Therefore, supervisors will play a central role to ensure that the financial institutions are well protected against CRFR. While banks strengthen their CRFR management by improving data quality, modelling capacity and understanding of climate change and its transmission channels, supervisors, following a prudent approach, must make sure banks remain robust by applying appropriate judgement and supervisory tools to mitigate uncertainty and risk underestimation. In particular, supervisors should consider increasing the Pillar 2 requirement capital (P2R).

When badly managed, idiosyncratic risks lead to systemic risks through contagion. The 2023 banking turmoil demonstrates how individual institutional collapses can propagate throughout the system, prompting government interventions to prevent contagion risk.^[6] Systemic risk can emerge from a confidence crisis, amplifying the initial shock. Investors and financial markets may discover that asset valuations or financial data were misleading or inaccurate, triggering a downward spiral of distrust across the entire system. The mismanagement of CRFR opens the door to this risk.^[7] Capital buffers serve as a critical safeguard in such scenarios. By providing institutions with additional capacity to absorb losses during systemic events, these buffers help maintain trust in the institution’s operational resilience.

III. Addressing systemic risks

According to scientists, the world is on track towards 2.8°C of warming by 2100,^[8] significantly deviating from the Net-Zero pathway established during COP21 in 2015. Current climate change mitigation policies remain insufficient and, with the recent policy reversals in the US and the EU, the likelihood of a timely and orderly transition is quickly diminishing. From a financial stability perspective, this trajectory gives rise to at least two major systemic risks:

• An abrupt transition to meet the Paris Agreement targets, driven by strong policy changes or technological disruptions, potentially leading to sharp asset price revaluations (known as Minsky moments) and stranded assets
• Uncontrolled global warming, where breaching climate tipping points causes devastating impacts for European societies and financial markets^[9]

A. Systemic dimension of an abrupt transition

The current global trajectory is untenable and risks triggering tipping points. Eventually, societies will need to take radical steps to prevent future physical climate impacts and limit global warming to 2°C. Societies have demonstrated a willingness to adopt highly disruptive policies when confronting systemic risks, most recently during the COVID-19 crisis, when governments imposed lockdowns despite financial repercussions. When addressing a systemic risk, first, supervisors have to evaluate its size and riskiness.

Systemic dimension. Transition risks will affect all exposures linked to high climate and environmental impact. For example, a carbon tax will impact all companies with high GHG emissions rates. According to the EBA dashboard based on banks’ pillar 3 ESG disclosure^[10], exposure to “sectors highly contributing to climate change” represents, on average, 66% of EU banks’ total credit exposure to non-financial corporates (NFC), with average values exceeding 80% in several EU Member States. This estimate is a lower bound of the possible exposure to sectors impacted by transition risks, as it only considers the first-round effects of transitioning. Moreover,  Non-Bank Financial Institutions (NBFI), which are also exposed to this risk (likely to be largely unmanaged), could amplify the systemic impact of a transition risk shock.

Riskiness assessment. In recent years, substantial work has assessed the economic and financial impacts of climate change. The Network for Greening the Financial System (NGFS), an international forum of central banks, has produced several batches of climate scenarios, assessing economic and financial impacts of both transition and physical risks.^[11] Among these scenarios, a “Sudden Wake-Up Call” (SWUC) scenario considers the impact of an abrupt transition within the next 5 years. This scenario has shown material impacts on the probability of default of key sectors contributing to climate change.

B. Systemic dimension of physical risks

When assessing financial risks arising from physical events, it is essential to distinguish between acute physical risks and chronic physical risks. Acute physical risks, such as heatwaves, wildfires, droughts and floods, are local and specific, causing significant losses at a particular point in time. These risks can be viewed as unexpected losses and are best addressed through the idiosyncratic approach described above. In contrast, chronic physical risks, such as sea-level rise, ocean acidification and shifting precipitation patterns, represent global phenomena with lasting effects. They can’t, therefore, be fully captured by a microprudential approach. Chronic physical risks are linked to climate tipping points, which are thresholds that, once crossed, lead to irreversible and systemic changes.

The financial impact of tipping points is currently difficult to quantify, but they are certain to be a threat to financial stability: crossing the tipping points will cause major disruptions to ecosystems, inflicting huge physical damages and socio-economic effects such as hunger, mass migrations and supply chain disruptions.^[12] Chronic physical risks will also affect the severity and frequency of acute physical risks, potentially triggering Minsky moments as specific institutions’ risk assessments could become rapidly outdated. The inability to predict the exact scale or timing of their financial impacts should not prevent financial regulators from addressing systemic risks.

Systemic dimension. Chronic physical risks and tipping points have been recognised by climate scientists as a “catastrophic threat” for humanity.^[13] International financial supervisory authorities have also recognised the systemic dimension of CRFR, with the Bank for International Settlements introducing the idea of “Green Swan”^[14] to define it.

Riskiness assessment. As stated above, in case of “Green Swan” events, despite high certainty that chronic physical risks and tipping points would be devastating for society and the economy, it is highly complex to provide a quantitative assessment of these risks given their forward-looking nature, unpredictability and the lack of historical data. This shouldn’t be a reason for financial regulators and supervisors to adopt a wait-and-see approach. On the contrary, this casts doubts on the ability of regulators and supervisors to deliver on their financial stability mandate, or whether the current framework is well-suited to manage the systemic risk of climate change. Prudential rules, particularly on macroprudential buffers, should allow a degree of latitude in terms of risk assessment when strong certainty about the materiality and the likelihood of occurrence of risk exists. For example, in the case of macroprudential buffers, the riskiness assessment could also rely on evidence from relevant scientific domains (IPCC reports, climate scientists’ consensus) instead of on narrow approaches such as quantitative financial analysis to implement necessary preventive actions. Evidence indicates that the neoclassical economic and financial models have been developed without accounting for the complex interactions between the environment and economic and financial systems.^[15] Given that the existing prudential frameworks are largely based on these models, climate-related financial risks remain underpriced and insufficiently considered.

C. Update of the current macroprudential framework

The macroprudential framework, particularly macroprudential buffers, can effectively address CRFR. The focus on buffers stems from their role in building loss-absorption capacity and their possible use in a preventive manner. These particularities could be considered for systemic risks arising from climate change. Indeed, systemic risks stemming from chronic physical risks and an abrupt transition have both exogenous dynamics (external shocks to financial institutions) and endogenous dynamics (the impact of banks’ business activities and exposures on climate change and, hence, the buildup of these risks). Endogenous effects are negligible at the micro level: an individual institution’s contribution to climate change is minimal compared to the CRFR it may face. At the macro level, however, these effects are significant. What the banking sector finances today directly impacts global temperature rise. Consequently, these impacts shape chronic physical risks and the speed and dynamics of the transition – whether it occurs in a timely and orderly manner or is delayed and abrupt. From a prudential perspective, this logic could inform the design of a macroprudential buffer. The buffer would be calibrated to the size of the exposure contributing to climate change, thus protecting banks against transition risks and preventing the buildup of chronic physical systemic risks.

Under the current framework, the most straightforward option to mitigate CRFR is SyRB, or sectoral SyRB.^[16] This buffer, implemented at the national level, is flexible and can be applied to a specific subset of exposure. However, its implementation could be challenging under the existing guidelines, as the supervisory risk assessment relies on a data-driven materiality analysis and a quantitative calibration, which do not include environmentally relevant metrics.^[17] The lack of historical data on CRFR and its forward-looking dynamics makes finding a robust calibration challenging. This leads to a paradox: supervisors are constrained in their ability to address these financial risks despite clear scientific warnings about the possible devastating impacts of climate change.

Conclusion

Recognising the systemic risk of climate change, the EU must lead by example, avoiding a regulatory “race to the bottom” and instead strengthening its climate risk mitigation efforts, particularly by tackling undermanaged CRFR. At the institutional level (microprudential perspective), supervisors should adopt a precautionary approach while banks strengthen their ESG risk management. At the systemic level, proactive measures, such as building loss absorption capacity and preventive capital buffers, would bolster resilience to climate shocks. This forward-looking, prudent approach could attract investors to the EU economy and financial sector, giving the EU a competitive edge in dealing with future climate-related crises. By acting now, the EU can set a global standard and incentivise others to follow, catalysing systemic change and amplifying collective impact.

Thomas Larible, Finance Watch

[email protected]