Banks that choose not to adhere to new principles regarding climate-related financial risks will ultimately pay the price; Fitch Ratings has warned.
The Basel Committee on Banking Supervision’s principles, issued on 15 June, call for the effective management and supervision of climate-related financial risks.
The principles augment the Basel Framework, and cover corporate governance, internal controls, risk assessment and management, and reporting.
They seek to provide a common baseline for all banks and supervisors in Basel Committee member jurisdictions, and the Committee expects them to be implemented as soon as possible.
The principles will up the ante for jurisdictions that have, so far, lagged behind with efforts to reflect climate and sustainability risks in their supervisory guidelines. The EU authorities are the most advanced in their progress.
The announcement will generate increased reputational and conduct risks for banks as regulators step up their scrutiny of banks’ climate risk and sustainability pledges
The principles emphasise the growing importance of environmental, social and governance (ESG) for bank supervisors.
Banks that fall short of the evolving climate-related requirements will increasingly face adverse reputational, regulatory and ultimately, financial consequences; the American credit rating agency predicted in its recent announcement.
The explicit requirement for consistency between what the banks are actually achieving and what they’re telling the public will likely lead to heightened market attention.
Said discrepancies could cause profound reputational damage, as highlighted by recent high-profile greenwashing claims.
In May 2022, the US Securities and Exchange Commission (SEC) charged BNY Mellon‘s fund-management arm for misstatements and omissions about ESG considerations in making investment decisions, landing them with a $1.5million penalty.
The SEC is also reportedly investigating the asset-management division of Goldman Sachs over ESG claims made by its funds. The forthcoming European Central Bank (ECB) climate stress test will require participating banks to consider the extent of operational risk events, including litigation and fines, within its stress and scenario analysis.
Existing regulations set out by the EU already require banks to disclose how they link remuneration to sustainability, with Fitch Ratings suggesting that the Basel principles could lead to the evolution of similar requirements in other jurisdictions.
The principles state that a bank should consider whether the incorporation of material climate-related financial risks into its business strategy and risk-management frameworks may warrant changes to its compensation policies.
The Basel climate principles are broadly aligned with those recently proposed by two US federal banking regulators – the Office of the Comptroller of the Currency (OCC) in December 2021, and the Federal Deposit Insurance Corporation (FDIC) in March 2022.
However, as highlighted in the credit agency’s original statement, while the draft FDIC principles are targeted at banks with over $100billion of assets, the Basel principles are for all banks, although they should be applied proportionately depending on each bank’s size, complexity and risk profile.
The scenario analysis and stress-testing principles to assess potential exposures and losses under a range of climate pathways, in particular, are only aimed at large, internationally active, banks. Smaller banks often lack the resources and data needed to conduct sophisticated analyses.
The Basel principles stipulate the assessment of financially material climate risks throughout the credit lifecycle – from client onboarding to the ongoing monitoring of clients’ climate-related credit risk profiles.
The principles also recommend that banks should carry out regular assessments of climate-related financial risk concentration in highly exposed sectors and geographies.
The credit agency expects the principles to enhance the climate-risk components of existing pillar two supervisory review processes, although it is still not clear whether climate-related financial risks will eventually be incorporated into pillar one minimum capital requirements.
Many larger banks, mostly in Europe and the Asia-Pacific region, have made a start on implementing similar principles disseminated by supervisors. However, the industry as a whole faces significant challenges in implementing sustainability disclosure principles, particularly for scope three financed emissions, and in adapting to the wider implications of climate change.