Central banks and financial supervisors worldwide are making progress in the identification, assessment, and management of climate-related financial risks. 

Banks are increasingly being required by regulators to address climate risk. Some have begun, but many must still develop plans, build capabilities, and develop risk-management frameworks. Proactive regulatory agencies in Europe, Britain, Australia and Japan already have issued climate-risk-related mandates or guidance to the financial services industry. Banks with business clients in these regions are facing an increasing regulatory burden in managing climate and environmental risks. As regulatory authorities in Singapore and Hong Kong implement increasingly detailed climate-related risk management requirements, banks in the region are also facing challenges engaging clients in data collection, risk assessments, and transition planning. Generally speaking, financial authorities worldwide are making progress in becoming more concrete in their efforts related to climate risk management.

Climate-risk-management matters

Financial institutions face exposures to climate-related risks, both physical damages, such as harm to borrower businesses operations, properties, and supply chains caused by increasingly intense storms, floods, wildfires, and droughts (often called physical risks), as well as the transition to a lower-carbon economy, such as declines in value in borrower fossil-fuel businesses and reserves (often called transition risks). As facilitators and providers of capital, financial institutions have an integral role to play in economic development, which now includes managing physical and transition risks from climate change. Consequently, banks should strive to ensure their internal reporting systems are able to track significant climate-related financial risks and generate timely information that allows for effective board and senior-management decisions. They also need to evaluate the degree to which their physical infrastructure, employees, customers, and suppliers are exposed to extreme weather events.

Knowledge about climate-related and environmental risks will also facilitate banks’ ability to disclose precisely the implications for their own risk profiles, as well as efforts to align their portfolios with Paris agreement targets. Through all of these changes, greater climate-risk awareness in banking will eventually have broad benefits for other industries – and society at large. These actions are crucially important to banks of all sizes, so that they can take active steps to reduce risks before the issue becomes more dire.

Financial regulators and their drive for action

In September 2022, the Federal Reserve Board announced that six of the nation’s largest banks would participate in a pilot climate scenario analysis exercise. The goals is to enhance the ability of supervisors and firms to measure and manage climate-related financial risks. During the pilot, participating organizations will assess the impact of various scenarios on specific portfolios and business plans. Following that, the Board will assess firm analyses and work with firms to create ability to manage climate-related financial risks. The Board intends to publish aggregate findings from the pilot, reflecting what has been learnt about climate risk management methods and how insights from scenario analysis may aid in identifying potential hazards and promoting risk management practices. There will be no firm-specific information given. Shortly after the announcement of the Federal Reserve Board, the Swiss Financial Market Supervisory Authority, FINMA, issued a supervisory notice on climate risk disclosure in the last week of November. According to this supervisory notice, the top banks and insurance businesses are required to disclose their significant climate-related financial risks. They must describe the impact of climate risks on business and risk strategy, as well as their impact on the existing risk categories. Institutions must also disclose the risk management structures and methods they utilize to detect, assess, and mitigate risks. This includes quantitative data as well as descriptions of the procedures employed. Institutions must also disclose the governance structure they consider to handle financial risks associated to climate change. Finally, they must examine how material they believe the risks are, as well as the criteria and valuation procedures used to make this determination. Meanwhile, the European Banking Authority has published binding standards for Pillar 3 disclosures of ESG risks, setting out mandatory, uniform disclosure requirements and providing additional clarity for banks. The final draft implementing technical standards (ITS) proposed comparable disclosures to show how climate change may exacerbate other risks on institutions' balance sheets, how institutions are mitigating those risks, and their ratios, including the GAR, on exposures financing taxonomy-aligned activities, such as those consistent with the Paris agreement goals. The ITS will update the final draft ITS on public disclosures by institutions with the strategic goal of developing a single, comprehensive Pillar 3 framework under the CRR that should combine all applicable Pillar 3 disclosure requirements.

A step in the right direction

The measures taken by financial authorities are a step in the right direction, as the safety and soundness of banks are crucial to the prosperity of their respective country. In fact, financial institutions are exposed to physical and transition risks not only from climate change, they are actively exacerbating these risks through continuing to provide significant funding to activities which are amplifying climate change. Financial institutions face risks to their operations as well, as extreme weather events may shutter offices and data centers. While climate change itself occurs over long periods of time, its effects are likely to manifest themselves in the financial system in event-driven shocks that move the system to a new state of asset impairment, increasing credit risks, and increasing costs. The risks of major macroeconomic impacts are driven mostly by global commodity price decreases brought about by changes to global climate policies.