NGFS Report Explores Quantification of Climate Risk Differentials
The Network for Greening the Financial System (NGFS) published two reports to aid central banks and regulators in their oversight of the financial sector and in their central bank operations: one report examines the quantification of climate risk differentials in Pillars 1, 2, and 3; the other report presents key takeaways from a study on how, and to what extent, climate-related risks are incorporated into conventional credit ratings, also highlighting the expectations and needs of central banks as users of such ratings.
Report on climate risk differentials
The report provides an update on existing analyses and practices in relation to green/non-green classification frameworks and the methodologies used by financial institutions, credit rating agencies, and supervisors to assess and quantify financial risk differentials. The analyses finds that financial institutions are moving away from classification-based, backward-looking analysis of risk differentials to a more granular, forward-looking assessment of counterparties’ vulnerability to climate-related risks. The report also looks at the lessons learned from supervisory authorities and regulators’ perspectives on risk differentials and a possible way forward. The report notes that the supervisory community has been exploring ways to measure and mitigate the impact of these risks on financial stability and one of the avenues explored by supervisors is the adjustment of Pillar 1 capital requirements following a risk-based approach. However, given the current data and methodological limitations, introducing adjustment factors in the Pillar 1 capital framework using conventional risk differential analysis based on historical data remains a challenge.
However, in light of the discussed practices, the report highlights that there may be greater potential to consider Pillar 2 measures, when addressing material idiosyncratic climate-related and environmental risks faced by individual financial institutions—though this does not exclude potential use of Pillar 1 tools. Considering climate-related and environmental risks as part of Pillar 3 requirements could also be beneficial, given the general use of disclosures in facilitating measurement and monitoring of these risks. Additionally, NGFS has identified three key strands of work for the supervisory community that could improve the resilience of financial institutions to climate-related and environmental risks:
- Supervisors could seek to further their understanding of the range of potential risk differentials as manifested through scenario analysis and stress testing (including at the individual financial institution level).
- With a view to enhancing the management and monitoring of transition risk in a forward-looking manner, supervisors could examine the relevance and extent to which financial institutions should consider their counterparties´ transition plans.
- Supervisors could further advance their understanding of the impact of environmental and climate-related risks on credit ratings and internal credit risk modeling at financial institutions.
Report on credit ratings
The report examines how and to what extent credit rating agencies incorporate climate-related risk factors into their credit ratings. Monetary policy implementation at many central banks relies on credit ratings to assess the creditworthiness of issuers and other financial market entities. Therefore, the degree to which credit ratings reflect material risks, including climate-related risks, is of great interest to the central banking community. The report finds that despite credit rating agencies considering environmental, social, and governance (ESG) and climate-related risk factors in their credit ratings, there is still a lack of transparency surrounding the methodologies used by the rating agencies to incorporate climate-risk factors and how these factors contribute to the final rating. Central banks as well as market participants are aware of the current limitations of credit rating agencies’ credit ratings in fully capturing climate-related risks. More work and knowledge-sharing within the central banking community will be needed to properly address climate-related risks. In the meantime, central banks may apply their own analysis to complement the information in traditional ratings of credit rating agencies.
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Keywords: International, Banking, Insurance, ESG, Climate Change Risk, Disclosures, Credit Risk, Scenario Analysis, Stress Testing, Credit Ratings, Basel, Pillar 1, Pillar 2, Pillar 3, Regulatory Capital, Credit Risk Modeling, NGFS, Headline
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