Bank of England Climate and Capital conference

During the October 19-20 Climate and Capital Conference, the Bank of England’s (BoE) representatives along with financial regulators, academics and industry experts discussed the appropriateness of the current capital framework to address climate-related financial risks. In view of the participants, climate risks are multi-faceted, diverse and will materialise both within firms and across the system which necessitates addressing these risks within both micro- and macro-prudential frameworks. Although changes to the existing capital regime are unlikely in the nearest future due to insufficient evidence in favour of introducing adjustments, the specificity of climate risk calls for further research on effective climate capital requirements and prompts delivery on the supervisory expectations on managing the financial risks from climate change by banks and insurers. The BoE’s official and updated view on the capital requirements is expected ‘in due course’, i.e. end of 2022.

Overview

The Conference was centred around three research areas identified in the PRA’s Climate Change Adaptation Report 2021:

• the appropriate place,
• the adequatetime horizon to reflect climate risk into the regulatory capital frameworks
• understanding uncertainty in climate-related financial risks and its implications for capital.

The participants discussed findings of the submitted research and shared their views on the work that lays ahead.

The appropriate place

The FED’s senior advisor Kevin Stiroh presented his and his colleagues paper on the conceptual road from climate change to capital for banks and insurers. Their primary conclusion was that while climate change has the potential to impact the regulatory capital regime in various ways, assumptions on how the loss-generating process may change needs to be precise to make the appropriate policy assessment. They also stressed the need to tie potential policy changes to a specific policy objective.

BoE’s Vicky Saporta stressed the fact that climate risks affect both the assets and liabilities of insurers. She also highlighted that capital buffers do not have an explicit role within insurance capital frameworks.    

Multiple papers were presented on how and whether to reflect climate-related financial risk into the banking micro- and macro-prudential frameworks. Within micro-prudential frameworks, considerations around i) adjusting risk weights for climate effects (RWAs calculation), ii) increasing minimum capital requirements for climate induced unexpected losses, and iii) use of Pillar 2 add-ons to account for uncaptured climate risks were discussed. In all three cases, researchers stressed the methodological challenges in making effective adjustments. In terms of macro-prudential frameworks, the potential role of capital buffers, and specifically the role of the systemic risk buffer (SRB) was discussed. The challenge, however, is to make sure such a buffer is introduced at the right time and the right level to avoid reduced credit provision by banks.

The adequate time horizon

Different views were exchanged on the appropriateness of existing time horizons for setting regulatory capital requirements. Currently, most capital requirements for both banks and insurers are set over a one-year time horizon (e.g. Pillar 1 requirements for credit, market and operational risks, Pillar 2A for banks, and Solvency II capital for insurers), with stress-testing frameworks extending to three, maximum five years. Certain longer-term risks, however, are already captured in, for example, credit ratings and market consistent valuation approaches for insurance contracts. The main challenge with extending time horizons is the potential front-loading of costs long before the materialisation of certain climate risks that depended on assumptions made. The participants agreed that banks and insurers should utilise scenario analysis to inform their risk management and business planning for the potential long-term impacts of climate change on their portfolios. However, the use of scenario analysis and climate stress tests for calibrating regulatory capital is not widely backed at present due to multiple limitations and deficiencies in the way climate risks are currently measured, as proved by the Climate Biennial Exploratory Scenario (CBES) exercise of 2021. 

The uncertainty

Finally, researchers and panellists agreed on material uncertainty around climate risks caused by severity, frequency and speed of physical events, and variety of potential transition paths and technological developments. Capturing climate-related financial risks is complicated by the fact that i) historical data cannot be relied upon for anticipating future losses, ii) there are non-linearities around transition and physical risks, and iii) materialisation of certain climate risks is irreversible meaning there is a permanent systemic shift. Indeed, the notion of uncertainty is the subject of risk and further work should be performed to build more advanced understanding of it and reduce the unknowns around climate change. 

Further remarks

The research findings and insights shared at the Conference call for further revision of the current regulatory capital framework. Although changes may not be introduced in the near future, revision of the coverage of climate risks by the current capital framework and industry consultation on the subject should be expected. UK banks and insurers are advised to track climate-related regulatory developments for both capital and non-capital requirements and expectations. In particular, they should further enhance their management of climate-related financial risks as outlined in the PRA’s SS3/19 Supervisory Statement and analyse the recently published Thematic feedback on the PRA’s supervision of climate-related financial risk and the Bank of England’s Climate Biennial Exploratory Scenario exercise. International banks and insurers are advised to follow closely the UK developments.

References

Climate and capital conference | Bank of England

Note to support the Bank of England’s Climate and Capital conference | Bank of England