Climate change conference: Reflecting climate change in bank capital – Pillar 1 or Pillar 2?

I was delighted to attend the Bank of England’s climate and capital conference earlier in the week. The objective of the conference was to chew over the complex issues associated with adjusting the capital framework to take account of climate-related financial risks.

As part of a panel session on how climate change financial risks could fit in to the micro and macro prudential framework, I was pleased to share the findings of a recent UK Finance report on Integrating climate risk into the prudential capital framework. This was created based on the lived-experience of the six UK banks that took part in the recent climate change stress test, with huge support from associate member KPMG.

Our report recommended that until there is evidence that climate risk will manifest itself differently from other financial risks, we should focus on applying existing regulatory tools, rather than fundamentally redesigning the framework. Of those regulatory tools, the stress testing component of the Prudential Regulation Authority (PRA) Buffer is the best immediate route to achieving this integration of climate risk as it is already based on forward-looking macroeconomic stress scenarios, so only minimal changes would be required to account for climate-related risks.

The main dependency would be reducing the current variation in modelling approaches, so the priority is to address this gap from a capability perspective. This is either by providing more prescriptive stress testing scenarios that remove modelling variations, or by improving modelling guidance.

We also observed that even with additional guidance it will remain challenging to appropriately model certain risk drivers such as increased geopolitical risk and global supply chain disruption from major natural disasters.

However, we did recognise that in the longer-term, climate change could be reflected in Pillar 1 as an amplifier of Credit, Market and Operational Risks. We liked Pillar 1 because of the transparency of the approach and the fact that the framework is sufficiently granular to capture decreases, as well as increases, in risk at an individual asset-level. Nonetheless we were insistent that any changes to Pillar rules should be agreed at the international level by the Basel Committee on Banking Supervision.

A key takeaway for me from the conference is that climate change is only going to happen once.  It is not reversible.  If we are to get to net zero by 2050 we have a lot of work to do this decade.

Consequently, because changing Pillar 1 is the work of a lifetime, time we don’t have, regulators and supervisors should focus on working together to improve stress and scenario testing based on shared learnings and capability building. They should recognise that perfection should not be the enemy of the good in working to meet such an important goal.