Capturing climate-related financial risks in the Basel Framework

There has been much debate about how best to reflect climate-related financial risks within the banking prudential framework. Initial regulatory focus was on sizing the exposure to the physical and transition risks of climate change, through exercises such as the Bank of England's (BoE's) Climate Biennial Exploratory Scenario (CBES) and the European Central Bank's (ECB's) stress test. UK and EU regulators have set out clear expectations for banks to reflect these risks in their risk management frameworks, and good practice has started to emerge, for example via thematic feedback from the PRA (PDF 243KB) and ECB (PDF 745KB) in Q4 2022 (for more details see here).

In December 2022, the Basel Committee for Banking Supervision (BCBS) published a short set of FAQs (PDF 297KB), clarifying how climate-related risks should be captured in the existing Basel Framework and incorporated into banks' Pillar 1 calculations. The FAQs are an important marker in the climate capital debate as they appear to support the view that the existing prudential regime may be sufficient to capture these risks — and provide further guidance to banks on how to do so.

Key clarifications in the FAQs include:

• Calculation of risk weighted assets (RWA) for credit risk — to the extent that the risk profile of a counterparty is affected by climate-related risks, banks should consider counterparty creditworthiness as part of their due diligence procedures. These risks should be integrated in either their own credit risk assessments or when using external ratings. This also applies to covered bonds and their issuing banks.
• General corporate exposures — banks in jurisdictions that do not allow the use of external ratings for regulatory purposes may assign a 65% risk weight to exposures to “investment grade” corporates. When determining whether a given corporate meets the investment grade definition, banks should evaluate how material climate-related risks, including under adverse conditions, will impact the capacity of the corporate to meet its financial commitments in a timely manner. Banks should also rely on a systematic credit review process to identify, at an early stage, whether the credit quality of the corporate has decreased such that it no longer meets the “investment grade” definition.
• Specialised lending — when determining whether project finance should be classified as "high-quality", banks should consider the extent to which climate-related risks will have an adverse impact on the ability of the entity to meet its financial commitments in a timely manner. Banks should evaluate these impacts on an ongoing basis.
• Regulatory real estate exposures — national supervisors have a duty to evaluate whether risk weights for real estate exposures are appropriate in their jurisdiction. National supervisors must consider the impact of weather-related hazards, regulatory and political transition risks and changes in consumer behaviour when making this assessment. Additionally, banks should determine whether the current market value incorporates the potential changes in the value of properties emerging from climate-related financial risks, including but not limited to those listed above.
• Internal-ratings based (IRB) approach — when using the supervisory slotting criteria for specialised lending, banks should analyse how climate-related risks could negatively impact the assignment to a category. This analysis should include impacts on financial strength, political and legal risks, physical risks and asset characteristics. The mitigation of relevant risks should also be considered. When assigning ratings to borrowers and instruments, banks should consider material and relevant information on the impact of the risks on the borrower's financial condition and facility characteristics. This includes physical and transition risks and their mitigation. Analysis should be performed both during onboarding and as an ongoing process. When information is insufficient, banks should be conservative in assigning grades.
• Ratings assignment horizon — banks should assess whether climate-risks will have an impact on obligors' ability to perform and this information should be integrated in rating assignments. Data should be collected at an appropriately granular level.
• Stress tests used in assessment of capital adequacy — a bank that uses the IRB approach should consider climate-related risks that may significantly impact its credit exposures within the assessment period.
• Overall requirements for estimation (structure and intent) — when estimating probability of defaults (PDs), loss-given defaults (LGDs) and exposure at default (EAD), there are challenges that include the range of impact uncertainties, limitations in the availability and relevance of historical data describing the relationship of climate risk drivers to traditional financial risks, and questions around the time horizon. Banks that have portfolios materially exposed to climate-related financial risks should consider these directly in estimates, adding a margin of error to reflect data deficiencies or scarcity.
• Requirements specific to PD estimation — corporate, sovereign and bank exposures — when mapping internal PD grades to the scale used by an external credit assessment institution, banks should consider whether the scale reflects material climate-related financial risks. Where it does, banks should critically evaluate the models and methods used given challenges with data sources, granularity and historical time series. Where it does not, banks should consider whether adjustments are appropriate to mitigate this limitation.
• Requirements specific to own-LGD estimates — standards for all asset classes — when assigning ratings to facilities, banks should consider material and relevant information on the impact of climate-related risks on the facility characteristics. An effective process to maintain relevant data should be established. Where a bank has insufficient information to estimate the LGD, it should consider whether a more conservative approach should be taken. Banks should add a margin of conservatism due to data deficiencies, such as poor data quality or scarce climate-related data, and to other sources of additional uncertainties.
• Calculation of RWA for operational risk (OPE) — to ensure that losses stemming from climate-related risks are identifiable, losses whose root cause could stem from relevant risk drivers should be identifiable from the loss database. A bank that is perceived to misrepresent sustainability-related practices or the sustainability-related features of its investment products could face litigation. Operational risks (e.g. power cuts) may also affect services and communications.
• Calculation of RWA for market risk (MAR) — banks should consider material climate-related risk drivers in their stress -testing to assess the potential impact on market risk positions, including the impact of a sudden shock to the value of financial instruments, correlations between risk factors, and the pricing and availability of hedges. Material climate-related financial risks should be incorporated iteratively and progressively in stress-testing programmes and internal capital assessment processes (ICAAPs) as the methodologies and data used to analyse these risks mature over time and analytical gaps are addressed.
• Liquidity Coverage Ratio (LCR) — when assessing the impact on net cash outflows or the value of liquidity buffer assets, banks must consider material climate-related financial risks. Supervisors should consider material climate-related financial risks among the range of other considerations in determining a response to a bank's use of high-quality liquid assets (HQLA). For example, climate-related risks may impact both prevailing and forward-looking assessments of macroeconomic and financial conditions that are relevant in addressing a reported LCR below 100%, consistent with the overall approach to the prudential framework.
  

The FAQs serve as a helpful guide on what the BCBS considers good practice and how firms should approach their Pillar 1 calculations. However, they do not constitute binding requirements and in due course, they may be supplemented by specific requirements from the PRA and ECB. The BCBS will issue additional FAQs as needed, to facilitate implementation of the existing Basel Framework, and as the availability of sufficiently granular data and consistent measurement methodologies for climate-related risks improves over time.