BCBS Report Concludes Basel Risk Categories Can Capture Climate Risks
BCBS published two reports that discuss transmission channels of climate-related risks to the banking system and the measurement methodologies of climate-related financial risks. The reports provide a conceptual foundation for the next phase of the Basel Committee work to identify potential gaps in the Basel Framework and consider measures to address them. The key finding of the analyses is that the drivers of climate risk can be captured in traditional financial risk categories, but additional progress is needed to better estimate these risks. As key challenges are addressed, the ability to estimate and effectively mitigate climate-related financial risks will improve.
The report on drivers and transmission channels of climate risks explores how climate-related risks arise and affect both banks and the banking system via micro- and macro-economic transmission channels. The report notes that economic and financial market impact of climate-related risks can vary based on geography, sector, and economic and financial system development. The report concludes with two recommendations for areas of focus in the future public, private, and academic work:
- Since the impact of climate risk drivers can be observed through traditional risk categories (such as credit risk, market risk, liquidity risk, operational risk, and reputational risk), consideration could be given to the way these risks can be addressed in the existing Basel framework. Part of BCBS' near-term work on climate change would be to identify gaps in the Basel framework, in terms of inadequate consideration of climate-related financial risks. This mapping exercise would be comprehensive and could act as a conceptual foundation for the future work of BCBS in exploring possible measures to address the identified gaps.
- Existence of research and accompanying data that explore how climate risks feed into the traditional risks is limited. A better understanding of risk drivers and their transmission channels, across all risk types, would be gained from further research. Research would also benefit from more granular information that is often privately held—for example, more granular borrower data for credit risks.
The report on measurement methodologies provides an overview of conceptual issues related to the measurement of climate-related financial risks and describes current and emerging practices of banks and supervisors in this area. The report highlights the following key findings:
- Climate-related financial risks entail unique features, which means that sufficiently granular data and forward-looking measurement methodologies are needed to address them.
- To date, measurement of climate-related financial risks has centered on mapping near-term transition risk drivers into bank exposures. Credit risk measurement has attracted the most effort, with a lesser focus on other risk categories. Initial scenario analyses and stress tests have in many cases focused on selected portfolios, or exposures for transition risks, and selected hazards for physical risks.
- Key areas for further analysis relate to gaps in data and risk classification, as well as methodologies to address uncertainties associated with the nature of climate change and the potentially longer time horizon for risks to manifest.
Keywords: International, Banking, ESG, Basel, Credit Risk, Market Risk, Operational Risk, Data Gaps, Climate Change Risk, Liquidity Risk, Scenario Analysis, BCBS
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Michael Denton, PhD, PE
Dr. Denton provides industry leadership in the quantification of sustainability issues, climate risk, trade credit and emerging lending risks. His deep foundations in market and credit risk provide critical perspectives on how climate/sustainability risks can be measured, communicated and used to drive commercial opportunities, policy, strategy, and compliance. He supports corporate clients and financial institutions in leveraging Moody’s tools and capabilities to improve decision-making and compliance capabilities, with particular focus on the energy, agriculture and physical commodities industries.
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