Basel Committee Announces Principles for Effective Management and Monitoring of Climate-Related Financial Risks | Shearman & Sterling LLP

Introduction

The Basel Committee on Banking Supervision recently published 18 principles that banks and their supervisors should consider when dealing with financial risks related to climate change. Recognizing the climate risks threatening banking institutions and the wider financial sector, the Committee issued 12 principles for bank management and six principles for banking supervisors. In particular, the principles cover topics related to corporate governance, internal controls, risk management, monitoring and reporting, as well as capital and liquidity.

As the global standard-setting body for internationally active banks, the Committee does not issue rules or regulations itself, but rather works with central banks and agencies to develop common approaches to monitoring. These climate-related principles, which the Committee expects member jurisdictions to implement “as soon as possible,” are the latest and broadest articulation of what global banking regulators should consider when ‘they seek to address climate-related risks in an effective and coordinated way.

Management Principles

The Committee has issued 12 principles that banks should adopt to manage climate-related risks. These principles cover topics ranging from corporate governance to scenario analysis.

The Committee recommends that banks adopt a process for assessing the impact of climate-related risk factors on the bank, which includes understanding short-term and long-term risks. Banks should consider how climate-related risk factors might alter the environments in which they operate. To ensure that climate risks are not overlooked, a bank’s board and senior management should assign climate-related responsibilities to specific members or committees. Directors and senior managers should be trained, including through internal workshops or with the support of outside experts.

Banks should embed policies and procedures that address climate-related risks throughout their organizations. In addition, a bank’s board and senior management should ensure that climate-related risks are clearly defined and accounted for in the bank’s risk appetite framework. Banks should also undertake “regularly” a “comprehensive assessment” of climate-related risks and set clear definitions and thresholds of materiality.

In particular, banks should integrate climate-related risks into their internal control frameworks across all three lines of defence. As part of the first line of defense, staff should assess climate-related risks during customer onboarding, credit application processes, as well as during ongoing monitoring and engagement with customers, as well as during approval processes for new products or activities. In the second line of defence, the initial assessment should be reviewed and challenged by an independent group within the bank, while the compliance function should ensure compliance with applicable rules and regulations. The third line of defense requires an internal audit to ensure the quality of the overall framework.

The Committee also asks banks to maintain sufficient capital in view of their climate-related risks. Among other things, banks should quantify their climate-related risks and incorporate these risks into internal capital assessment processes. Banks need to consider these risks over multiple time horizons when calculating the amount of capital required.

Banks must ensure that their internal reporting systems are capable of monitoring climate-related risks, and banks’ risk data aggregation capabilities must take these risks into account. Similarly, banks should consider the impact of climate-related risks on different areas of their business, including credit risk profiles, market positions, liquidity risk profiles and operational risk.

Finally, banks should use scenario analysis to determine the impact of climate-related risks on their business. Banks should also use scenario analysis to assess their climate risk strategies. In addition, banks should assess whether climate-related risks could lead to net cash outflows or the depletion of liquidity reserves, assuming both business as usual and stress conditions.

Monitoring principles

The Committee announced principles that bank supervisors should adopt to oversee banks’ climate-related risk measures. In general, supervisors should satisfy themselves that banks comply with the principles set out above. Thus, supervisors need to assess whether banks can identify and manage climate-related risks. Supervisors should also identify which board members or committees oversee climate-related risks and whether banks have a framework in place across their organization to protect against such risks, including three lines of defense.

Similarly, supervisors should assess whether banks have properly considered climate-related risks in their management of credit, market, liquidity, operational and other risks. Supervisors should verify that banks’ boards and senior management receive accurate and appropriate internal reports on material climate-related risks.

When supervising banks, supervisors need to be proactive in ensuring that banks deal with these risks adequately. Thus, supervisors should incorporate a range of techniques, including follow-up action, setting expectations, and sharing information with other supervisors. Similarly, supervisors must have adequate resources and expertise. The Committee also encourages supervisors to work with the climate science community to stay informed about risks and help develop best practices in scenario design for banks.

Comments

The Basel Committee release is the latest sign that global banking regulators are taking seriously the myriad risks presented to the banking system by climate change. It is also an indicator of how climate change issues will be handled by banking regulators, with a strong emphasis on good corporate governance and risk management tasks. For US banks, many of the principles set out by the Committee are not new. The OCC and FDIC recently proposed their own principles for the safe and sound management of climate-related financial risk exposures. The Federal Reserve Board, for its part, has not yet done so, but it is highly likely that when it does, many of the themes contained in the Committee’s communiqué will be reflected in one way or another. other.

Although the Committee’s principles do not have the force or weight of a rule or regulation, they should still be taken seriously. Banks may wish to review them in light of their own climate risk planning. Particular attention should be given to areas of institutional weakness and whether outside experts and advice may need to be engaged to help plan the ‘gap’ assessment.

Special thanks to summer associate Patrick Nugent for his valuable contribution to this publication.

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