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Lack of data makes quantifying climate risk a challenge for banks: reports

19 April 2021 Amena Saiyid

A pair of reports by a global bank standards-setting body call for more research and data to quantify the varying economic and financial market impacts of climate-related risks.

Published 14 April by the Basel Commission on Banking Supervision (BCBS), the primary global standard-setting organization for central banks, the two separate yet complementary reports gauge the challenges of estimating climate-related risks for financial institutions. BCBS is one of nine committees that fall under the Bank of International Settlements (BIS).

Climate-related risk drivers and their transmission channels explores how climate-related financial risks arise and affect both banks and the banking system, while Climate-related financial risks - measurement methodologies examines current approaches for evaluating climate-related financial risks and identifies gaps.

"While a range of methodologies is currently in use or being developed, challenges remain in the estimation process, including data gaps and uncertainty associated with the long-term nature and unpredictability of climate change," BCBS concluded in a statement accompanying the reports

As these challenges are addressed, BCBS said, "the ability to estimate and effectively mitigate climate-related financial risks will improve."

A lens to tackle climate risk

The reports do not provide a definitive answer to the questions that central banks may have about quantifying climate risk on their balance sheets, but they provide a lens through which this issue may be tackled.

"It cautions that [bank] supervisors have studied selected portfolios and exposures for transition risk, and certain key physical risks, but lack frameworks permitting full and systematic assessment of climate risks, also using a time frame potentially suitable for macroeconomic risk management but inappropriate for climate concerns," Brian Lawson, senior economic and financial consultant to IHS Markit's country risk division, wrote in a 15 April note about the BCBS reports.

IHS Markit Head of Americas Regulatory Affairs Salman Banaei said these reports are valuable because "they will inform increased climate risk-related bank supervision."

The BCBS findings will have a downstream impact on bank clients as their financial activities increasingly begin to incorporate climate risk-related costs, Banaei said, adding this is because a bank's exposure to climate risk is a function of its clients' exposure.

Billions of dollars in losses

The banking industry is potentially exposed to the risks posed by climate-driven severe weather events, which, for instance, have caused billions of dollars in property damage that, in turn, have affected the portfolios of banks and other institutions backing those assets.

These risks can either be felt directly through severe weather events or as indirect transition risks driven by changes in in policy, advances in technology, or a combination of both.

In its report on climate-risk drivers, the BCBS found that existing risk frameworks --based on credit, market, liquidity, operational, and reputational risks -- can be used to assess climate-related risk, and there is no need for a new model. However, the same report also pointed out that existing analysis does not generally translate changes in climate-related variables to changes in banks' credit, market, liquidity, or operational risk exposures, or to bank balance sheet losses.

"Instead, the focus is on how specific climate risk drivers can impact: narrowly defined sectors of particular economies; individual markets; and/or a top-down assessment of the macro economy as a whole, " the report said, adding that more granular research is needed to understand the impacts.

The second report, which looked at methodologies, found that banks generally were measuring near-term risk drivers arising from policy changes in terms of bank exposure.

Both reports also found that the economic and financial market impacts of climate-related risks can vary according to geography, sector, and economic and financial system development, giving rise to a level of uncertainty that is yet to be factored into the various risks faced by banks.

Lawson also noted a key conclusion in the both reports that further supervisory work is required to cover "measurement gaps" regarding climate risk, which will require "new and granular" data collection and efforts to ensure consistent standards.

Dovetails with Fed's study

The BCBS reports also reaffirm what staff at the US Federal Reserve Board uncovered as it too attempts to study the potential vulnerabilities of financial institutions to "the consequences of climate change and the policies designed to mitigate that effect."

Although in the early stages, the Federal Reserve is finding that climate risks introduce a broad layer of economic and financial uncertainty to a wide range of financial institutions and markets, different sectors of the economy, and geographic regions.

"And the markets for those assets linked to those regions and sectors may face new risks that may diverge from historical patterns," said Elizabeth Kiser, associate director of the Federal Reserve's division of research and statistics, who is spearheading the study.

The Federal Reserve also has discovered that its key challenge is to translate climate risk into measurable economic and financial risks that contribute to the overall stability of the financial system.

Posted 19 April 2021 by Amena Saiyid, Senior Climate & Energy Research Analyst, IHS Markit

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