Bank Climate Risk Management II

Moorad Choudhry

34 years: Banking and Capital Markets

In this video, Moorad explores the impact of climate change on banks' risk management strategies. He discovers the regulatory drivers behind climate risk management, and learns about the crucial areas that should shape a bank's climate change risk policy review. From operational shifts due to climate impacts to regulatory compliance and sustainable lending practices, we unpack the essentials for navigating this evolving landscape.

Green Economy and Central Banks

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Bank Climate Risk Management II

9 mins 45 secs

Key learning objectives:

Understand the expected impact of climate change on banks
Outline what is driving climate risk management regulations
Understand the critical areas that should inform the review of a bank’s climate change risk policy

Overview:

Climate change significantly impacts banks' risk management frameworks, specifically their balance-sheet processes and the credit quality of corporate and SME customers. A study by McKinsey revealed that 15% of a sample portfolio from 46 European banks showed increased risk due to climate change. Regulatory bodies like the UK Prudential Regulatory Authority have mandated firms to manage climate change risks, leading to changes in governance, risk management, and stress testing scenarios. Banks have generally progressed in integrating climate change risks in their policies and governance frameworks, but understanding long-term balance sheet impacts requires more effort. Hence, a comprehensive risk management framework encompassing robust governance structures, risk management strategies, and a focus on scenario analysis is essential.

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Summary

What is the expected impact of climate change on banks’ operating models?

Climate change is expected to profoundly reshape banks' operating models. According to a 2020 McKinsey study, around 15% of European banks carried heightened risks from climate change. These risks, potentially leading to customer credit quality deterioration, will more acutely affect sectors such as real estate, energy, mining, and construction. Banks must adapt their risk management frameworks to include these climate-related physical and transition risks, causing substantial modifications in their balance-sheet processes.

What is driving climate risk management regulations?

Regulatory bodies, such as the UK's Prudential Regulatory Authority (PRA), are driving climate risk management regulations. The PRA's supervisory statement SS3/19 has led to the inclusion of Climate Change in the Senior Managers and Certification Regime (SMCR), impacting four areas:

Governance: The PRA expects board-level oversight, clear roles and responsibilities, risk appetite statements covering both short and long-term risks, and relevant skills and expertise for managing climate risks.

Risk Management: Firms must provide evidence of integrating climate risk management in existing frameworks. This involves the use of scenario analysis, stress testing, integration into the ICAAP capital adequacy assessment process, and development of tools for monitoring climate risk.

Scenario Analysis and Stress Testing: Firms should incorporate these in strategic planning, risk appetite, and business strategy. The process should consider transition pathways to a low-carbon economy and inform management actions for risk mitigation.

Disclosure: Firms should include relevant data in Pillar 3 of the Basel Framework, consider additional transparency, and actively evolve disclosure. Engagement in wider climate-related initiatives is also encouraged.

What are the critical areas that should inform the review of a bank’s climate change risk policy?

The critical areas for reviewing a bank's climate change risk policy are:

Acknowledging the bank's environmental responsibilities beyond legal and regulatory requirements, including impact management through lending activities.
Clearly defining roles and responsibilities from the Board to employees at all levels in adherence to regulatory rules and ESG matters.
Minimising the bank's carbon footprint by reducing environmental impact and improving environmental performance across various operational areas.
Developing products that encourage positive ESG and sustainability activities and establishing an ESG risk appetite that is reflected in lending policies.

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Moorad Choudhry

Professor Moorad Choudhry is a non-executive director at two UK financial institutions, having worked in London since 1989. He has experience in wholesale capital markets, treasury, ALM, and balance sheet management. Moorad's most recent role was as divisional treasurer at the Royal Bank of Scotland. He has also worked with Europe Arab Bank, KBC Financial Products, and JP Morgan. He is the author of "The Principles of Banking," which is currently in its 2nd edition.

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