IIF: Regulators try to reassure banks on climate stress tests

With this year’s annual meeting of the Institute of International Finance (IIF) focused on sustainability, all eyes are on the clues supervisory authorities might give about their role in managing climate risk in the financial sector. And there have been plenty of them.

The issue is now at the forefront of the sector more than ever, given the recent bottom-up climate stress test conducted by the French authorities. A similar process is currently being conducted by the Bank of England (BoE) through its Climate Biennial Exploratory Scenario (CBES), and one will be started next year by the European Central Bank (ECB) and European Banking Authority (EBA).

And while there apparently endless discussions around scenario analysis and net-zero targets, there are two fundamental questions on bankers’ minds about the outputs of the stress tests: Will they feed into capital requirements? And if they do, will that be explicit or implicit?

To judge by what they have said at the IIF sessions this week, regulators are – for the moment, at least – doing everything they can to push back on worries that they might be about to unleash new explicit capital add-ons because of the outputs from climate stress tests.

Andrea Enria, chair of the supervisory board at the ECB, says the institution will not be “jumping the gun” when it comes to capital requirements, although he also stresses that this did not mean a less stringent approach to the topic.

“What is important is that banks feel we are getting more and more serious and that they need to proactively manage climate risk,” he says.

Climate risk is gradually becoming part of the ECB’s Supervisory Review and Evaluation Process (SREP) for banks, but Enria says the bank will not be mapping the results of its climate stress tests into its Pillar 2 guidance capital buffer, for example.

That said there are other ways regulators can react, as Enria concedes. If a bank performed very badly in the exercise, whether through inadequacies in its processes or its data, the supervisor might conclude that its SREP credit risk score was “not in the right place,” he says. “So there could be an indirect impact through that channel, but that is not the main feature [of the tests].”

Chris Faint, the BoE’s head of division for climate, is of a similar mind and notes that succumbing to the temptation to wield regulatory power with abandon could create unintended consequences.

“There is lots of discussion over whether regulators should use their tools to penalize some sectors of the economy or incentivize others,” he says. “We caution against moving too quickly in that direction. If you create a disjoint between the amount of weighting or capital you put in one activity, you could be building up risk in the system or in an institution.”

But, like Enria, he also hints at possible shifts to this generous approach over time. “What we will be doing is looking at how we react to firms who are not developing fast enough; and that is more where capital could come in in the future,” he says.

François-Louis Michaud, executive director of the EBA, says it is important for the institution to move carefully through the European Union’s Capital Requirements Directive sequence of Pillar 3, Pillar 2 and Pillar 1, so as to avoid disruption and allow transition to take place in an orderly way.

Within Pillar 3 disclosure is the key element. A climate risk assessment conducted by the EBA earlier this year highlighted the data and disclosure gaps that exist, and the institution will be publishing its final Pillar 3 requirements for climate-related disclosures in the coming months, alongside supporting the European Commission’s work on the bloc’s green taxonomy and green asset ratio.

But Michaud also argues for a need to incentivize the banking sector to reform and this is where the Pillar 2 element, which requires firms to determine whether they need more capital than the Pillar 1 minimums would demand, kicks in. “[Climate risk] needs to be embedded in strategies, internal governance, risk appetite, capital planning and allocation,” he says. “They need to reflect the new nature of these risks.”

His view is that Pillar 1, which covers minimum capital requirements, is a different animal and much more complex. “There is also a need to start working on this so that we can prepare all the evidence and treatment,” he adds. “But, of course, we believe we are in this together. We are embarked on the same journey and collectively we will win or lose.”

That sounds like another way of reminding banks that regulators carry a big stick, but that any pain will be for their own good.

Those watching the regulators like the apparent broad agreement over approaches but caution that there is plenty of devil in the detail.

“Are supervisors aligned? At a high level, yes,” says Adam Gilbert, financial services advisory regulatory leader at consultancy PwC. “I think, though, that just beneath the surface there is still a way to go. I’m not sure there is alignment on how to use the supervisory or regulatory toolkit to achieve these objectives.”

One initiative that attendees at this year’s IIF meetings see as vital to progress on harmonization of global climate-related standards is the establishment of the International Sustainability Standards Board (ISSB). There are expected to be big announcements about this at the United Nations Climate Change Conference, COP26, in Glasgow in early November.

The board is being set up by the International Financial Reporting Standards (IFRS) Foundation and will sit alongside the International Accounting Standards Board.

The ISSB’s goal will be to develop a set of global sustainability standards that can be used as a baseline for individual jurisdictions to set their own disclosure rules. The target is to produce such a standard next year, based on what information is of most relevance to a company’s enterprise value. The hope is that existing standards setters will subsume their work into the ISSB, helping to reduce fragmentation, although there is no final decision on that yet.

Making traction on establishing credible standards is widely considered to be fundamental to any real work on climate disclosures and the resulting regulatory requirements.

“I cannot stress how important this is,” says Klaas Knot, president of the Dutch central bank and a member of the governing council of the ECB. “We need mandatory and consistent climate disclosures.”

A lack of standardization has long been the bugbear of the whole sustainable finance effort. The absence of consistent, comparable data and disclosure standards has left banks, corporate clients and investors floundering. There is recognition that while individual jurisdictions may well vary in their ambitions, globally active institutions need some baseline of interoperability between international and domestic requirements.

Knot doesn’t think the lack of data should prevent such standards from being established, even if they will inevitably be subject to gradual modification and upgrade. He thinks back to the establishment of Basel standards in the 1980s, when there was remarkably little data available on measuring credit risk, but a starting point was found based on a few standard risk weights.

To move forward now, he argues that three things are critical: there must be firm-level disclosures to allow investors to craft climate risk profiles for different institutions; there must be vulnerability analysis that recognizes the systemic component of such risks – that “the macro is more than the sum of the micro”; and that regulators around the world must compare notes.

The clarion call is for regulatory harmonization as far as possible when it comes to climate; and in this there is an intriguing contrast with other areas of regulation. While global banks spend much time and effort complaining about the lack of regulatory level playing fields in more traditional areas of supervision, for supervisors themselves the picture is less clear cut.

Ashley Alder, chief executive of Hong Kong’s Securities and Futures Commission, laid out at the IIF the challenge that regulators face all the time. Regulatory fragmentation is typically portrayed as an unalloyed negative because of the increased costs of compliance for institutions operating across jurisdictions and the potential for inefficiencies for all market participants. But standardization, he notes, can also create its own risks, in that a failure can have global implications that a more fragmented landscape might have prevented.

Central counterparties (CCPs) for the clearing of derivatives are one example. “You get nervousness around CCPs because there are very few of them,” says Alder. “This brings clear benefits for end-users and for the financial industry because you get big netting effects. But it also means there are few points of failure, as opposed to having many CCPs, where the netting effects would not be as high, but there would be more points of failure.”

The good news, from the perspective of those worrying about climate risks, is that this argument rarely applies to climate risks, which are already globally interconnected and demand a globally coordinated response. The catastrophic single point of failure here would be a failure to respond to the risks rather than anything that might be done to mitigate them.

Alder is also the vice-chairman of the board of the International Organization of Securities Commissions, which has been closely engaged with the IFRS Foundation on the creation of the ISSB and may in time endorse standards produced by it. He describes the ISSB project as a “game-changer”.

“Harmonization is really important in this area,” he says. “If you don’t have that, investors don’t have a way to compare institutions and then can’t make informed choices, which impairs the whole climate finance project.”

At every opportunity, regulators attending the IIF have been stressing the limitations of their mandates and the need for them to remain focused above all on the soundness of the financial sector, rather than using their tools to coerce banks into dropping certain kinds of activity in favour of others.

“I am a prudential supervisor, so the angle I take is risk focused,” says Enria. By pushing banks to actively manage climate risks, through having the appropriate expertise on their board or conducting internal stress tests or demonstrating the way in which their risk appetite framework is taking climate risk into account, Enria says that regulators will ensure that banks will by default play a positive role in transition.

“They will push for the correct pricing of the risk of transition and physical risk, and this will by itself be supportive of the transition to a low-carbon economy,” he says.

It is a view shared by Faint at the BoE. “We are focused on the financial risks, safety and soundness of the firms that we supervise,” he says. Since 2015, the BoE has been looking at how climate risks can impact those firms and in 2020 it made an explicit move to include climate change in its strategy.

“What that means is we are looking at how climate change, both physical and transition, can impact the safety and soundness of our firms… and to understand how they are responding.”

But Faint sees this as tied up with the chicken-and-egg issue of how the financial sector itself contributes to climate risks through its actions.

“Do we care about the ways the financial system impacts climate? Yes!” he says. “To the extent to which the financial system causes greater climate risks, it will give rise to greater financial risks.”

The ECB has told banks that it expects them to be much more active in managing the financial risks resulting from climate change and their clients’ responses to it, and has required them to begin assessing their own abilities to do just that.

“I must say that banks have been very candid with us,” says Enria. “They are not there in most areas yet.” The ECB’s response has been to ask how they intend to fill those gaps.

The EBA’s mandate is to ensure that the EU can rely on an efficient and stable banking sector. In the context of managing the transition of the bloc’s economies to lower emissions, Michaud says that its role is to enable banks to participate in that process efficiently while being able to withstand any resulting shocks.

But there are limits to what it can achieve. “Financial sector regulation is one policy tool… but it is not an industrial policy instrument,” he says.

He also recognizes that there are limits to what banks themselves can do. “It is not for the banking sector to force a change in the economy, but, given their central role, they are uniquely placed to act as a catalyst,” he says. “Banks can play a useful role to reach out to a wide array of people.”

In many respects, European and Asian regulators are at a more advanced stage than their counterparts in the US, which have not yet detailed how they will approach the task of stress testing their banking sector for climate risks. But that is not to say nothing is happening there. For example, the Federal Reserve is chairing the Basel Committee on Banking Supervision’s Task Force on Climate-Related Financial Risks (TCFR), which was set up in February 2020.

Kevin Stiroh, senior adviser for supervision and regulation at the Fed’s board of governors, told the IIF meeting that the TCFR is taking a gradual and sequential approach, starting with attempts to understand the transmission channels for climate risks.

“We are looking at safety and soundness, not to use the Basel framework to promote the transition to a low-carbon economy – that is not the goal of our taskforce,” he says. “That is important because different jurisdictions have different statutory mandates.”

What it is doing, however, is investigating ways in which climate financial risks could be addressed within the Basel framework.

Faint says that the supervisory role must be seen as a remit distinct from that of governments, which must take the lead responsibility for what many in the climate arena refer to as the ‘just transition’, a term that encompasses everything from shepherding hard-to-abate sectors towards a greener path to ensuring that developing economies are not treated more harshly than others simply for being at an earlier stage of industrial development.

“Developing policy for country transition is a major task and is appropriate for elected representatives,” says Faint. “Within that context we are keen to ensure that we don’t operate outside our objectives.”

That raises challenges for regulators in terms of penalizing or even incentivizing firms to embark on transition, as PwC’s Gilbert explains. “There will be a lot of technology and businesses that develop and are tried, and some will fail,” he says. “To the extent that we only look at one direction, incentivizing greening will entail risks and will need to be addressed in the capital framework as well.”

There are other potential risks in incentivizing green activities through, for example, lower capital requirements. “Bank capital is the last line of defence to absorb losses and it must be risk based,” says Tomohiro Ishikawa, head of the government and regulatory affairs office at Mitsubishi UFJ Financial Group (MUFG). “If a lower capital requirement was applied to green activities, it may provide an incentive for more loans, but it might lead to undercapitalization if it does not reflect the underlying risk.”

Additionally, pure green activities only account for a small portion of the overall economy. Where the money is needed most is in transition.

“Banks alone cannot complete this job because clients will have to become greener, not just our balance sheet,” adds Ishikawa. “We might want to do green finance, but however strongly we push it, it is clients who will decide.”

On the other side of the coin are penalties for the brown economy. Elsewhere at the IIF meeting, Citi chairman John Dugan argued that any attempt by regulators to tie new, climate-specific capital requirements to either side would be a mistake.

“I don’t think that climate change calls for a separate type of regulation that is unrelated to risk,” he says. “Capital requirements ought to be focused on the risk of loss to the bank. Climate change does present risks of loss, but they are not easy to quantify. But that is the right approach, not trying to achieve other government policies.”

A failure to stick to these principles would create a situation where credit allocation was being decided by something other than the market, he says. “If governments want to do that, they should do it through government policy, not through the banks.”

Gilbert agrees. “The voice of the people through legislators has to be reflected here,” he says. “It should not be the sole province of unelected officials when we are talking about impacts that can affect livelihoods or the fate of whole sectors of the economy.”

However, Dugan is encouraged by what he sees as signs that the regulatory community appears to be aligning on this issue. An additional piece of that puzzle should appear in the coming weeks with the publication of a keenly awaited report from the US Financial Stability Oversight Council.

“The hardest piece of this is: what are we doing with respect to our clients in terms of helping them transition?” Dugan adds. “That is a very substantial challenge, but we are not about to pull the rug out from under the current providers of energy.”

That is a point reflected in comments elsewhere at the IIF, with JPMorgan chief executive Jamie Dimon arguing on Monday that simply closing coal and nuclear plants is no answer, nor are measures that simply push dirty assets into the hands of private equity.

Similar thoughts come from BlackRock chief executive Larry Fink, who notes that such sales have already been seen. “That is not going to get us to net zero. We have just created a public-private arbitrage – which is insane,” he says.

But many IIF attendees note that clients are shifting their approaches in thoughtful ways. Barclays chief executive Jes Staley wonders whether the climate issue today is comparable to the technology landscape in 1995.

“Back then a lot of the big companies today didn’t exist and technology was at the start,” he says. “Today tech is 40% of global capital markets. So many companies from different industries now call themselves tech companies. Climate could be in the same place right now.”

In 20 years and it could be commonplace for all sorts of companies to talk about their climate agenda or how they play a role in net-zero transition. “There are great challenges, but we see an opportunity just as those who saw an opportunity in 1995,” Staley adds.

In climate-related regulation many roads lead to the same destination – scenario analysis. In this, the work of the Network of Central Bank and Supervisors for Greening the Financial System (NGFS) has been paramount. Set up in late 2017, the body now brings together some 95 central banks and supervisory bodies to develop a suite of climate-related scenarios that can form the basis for climate assessments by regulators and banks.

The NGFS scenarios – considered something of a gold standard for the way in which they cover both physical and transition risks – are now on their second iteration, published this summer. They will be upgraded regularly, according to Jean Boissinot, deputy director for financial stability at the Banque de France and secretary general of the NGFS.

“Patchy data is better than no data, but good data is better than patchy – and patchy scenarios are better than no scenarios,” he says. But those scenarios are getting less patchy: variables for specific sectors are beginning to be introduced, he says.

Sarah Breeden, executive director for financial stability strategy and risk at the BoE, also chair’s the macrofinancial workstream at the NGFS. She notes that the second iteration of the scenarios also added country-level specificity, but that it was important to develop more sector analysis, as well as potentially shorter timeframes.

And she sums up the challenge. “It is really hard to translate climate outcomes into economic and financial risks, so that is what we have sought to do through the NGFS scenarios, working with climate scientists and economic modellers.”

Banks across the world are now using the NGFS scenarios – with different degrees of sophistication. MUFG’s Ishikawa says his bank has been conducting what the Japanese Financial Services Agency calls a pilot scenario analysis that encompasses both top-down and bottom-up elements.

In its first phase, MUFG has selected more than 300 corporate clients for which it is preparing long term projections in line with NGFS scenarios. Importantly, says Ishikawa, these are not just based on high level inputs but also take information from the individual bankers who cover those firms. The bank then engages the clients to check how realistic its assumptions have been, as well as sourcing information to plug specific data or knowledge gaps.

Low-emission sectors are generally looked at with a top-down approach, with dirtier industries subject to the bottom-up analysis. Ishikawa says there have been three preliminary findings from the work.

The first is that the exercise has led to the topic becoming part of the mainstream agenda within the bank. Second, it has resulted in bankers across the firm – not just in the risk division – analyzing clients through a new lens of climate change risks that stretches well beyond loan repayment timelines. And third, since the process actively involves relationship bankers, he believes the analysis itself will help accelerate clients’ own transition to net zero.

But he warns of limits to the usefulness of the outputs – at least until banks have had the opportunity to refine them with repeated iterations.

“Scenario analysis is not a magic wand,” he says. “It may be useful for a regulator to understand macro exposure or risks at a sector level, but I think the outcome at a firm level is too broad brush and so is not an appropriate tool for risk management purposes.”

It was important, he says, for regulators not to jump to conclusions from such early work and for banks to conduct tests repeatedly so that parties could agree how to use the results – and how scenario analysis could continue to evolve.

For banks the topic is becoming all consuming. At BNP Paribas, chief risk officer Frank Roncey says he now spends about one-third of his time on climate issues, compared with less than 5% just three years ago. The bank first worked on establishing common standards across the group and then focused on collating data. It has now rolled out the first version of its group-wide environmental, social and governance (ESG) data platform, which gathers internal and external data and distributes it across the bank.

“Beyond this infrastructure aspect, we have worked on including ESG risk drivers, both transition and physical, into the framework of our global risk identification process,” he says. Those drivers are feeding into the bank’s internal capital requirements assessments, but a crucial part of that is work to assess the ESG profiles of individual clients.

To do that, the bank has a similar approach to MUFG, with relationship managers in the bank working with clients on questionnaires to gather data.

For all the reassurances they offer now, capital is clearly on the minds of regulators. “The purpose of capital is to ensure there is enough absorbency, but the challenge is that firms don’t always have the data so don’t know how much capital to hold,” says Faint. “We have asked firms to show us why they think their capital is not materially understated… but over the medium term what we need to do is think about the question more thoroughly.”

Time horizons present a new challenge in this respect. The UK prudential capital regime is calibrated for one-year risks, with the regulator requiring firms to hold enough resilience for that period. The big question now is to what extent it might want firms to hold capital beyond one year to account for climate risks.

There are other hurdles too, not least that current requirements tend to be calibrated around cyclical risks. “But climate risks will increase over time and can be quite jolty, so how should regimes reflect that – and should they?” says Faint.

The Bank of England is spending a lot of time thinking about these issues and is hoping to publish its conclusions soon. The EBA, meanwhile, is planning to release discussion papers in 2022 and might have a clearer idea of possible approaches to capital treatment by 2023, according to Michaud.

The substance of getting to that point will be complex, he adds. “We want to assess two things: do we have the evidence about risk factors and risk differentials to allow us to draw a line between positives and negatives; and does this evidence allow us to treat risks in a differentiated manner?”

Regulators fall over themselves to say they understand the various challenges that banks face, but they seem disinclined to cut them much slack because of them.

“There has been some noise from banks saying that we don’t have the data, customers don’t have the data, so it is difficult to fulfil expectations,” says the ECB’s Enria. But while he acknowledges the truth of the data gaps, he argues that the purpose of stress tests is to increase awareness of the risks and to push banks to develop proxy data to fill the gaps.

Faint agrees, noting that just because the data might be lacking, the risk doesn’t go away. He says the BoE encourages firms to be “creative” and has set expectations for them to show that they understand their risks by the end of this year.

“One thing we have asked firms to do is to allocate senior management that is responsible for delivering those expectations and we are speaking to those individuals to check that firms have embedded our expectations,” he says. “This is key because the better a firm understands its risks, the more it will be able to strategize and mitigate.”

Breeden says she has seen high engagement from the firms the BoE supervises. “They have been taking the opportunity to use [the CBES] as a way of driving through improvements in risk management and getting it embedded in their business,” she says.

“The CBES is granular and bottom up, which requires firms to engage with customers and get those forward-looking metrics,” she adds. That is a lot of work for the banks, as she concedes, but it is all the more important while global standards have yet to be agreed and while adherence to efforts like the Financial Stability Board’s Task Force on Climate Financial Disclosures is not yet mandatory.

It also highlights once again that overwhelming as the regulatory and supervisory task around climate risk is, it pales in comparison with the challenge facing national governments to pivot the world’s diverse societies into coordinated action to mitigate it.

As the world of decentralized finance and fintech illustrates every day, the traditional finance industry is often seen as a lumbering dinosaur, complete with its own occasional extinction-level events. But climate may yet prove to be one area where banking and banking regulation are, if not ahead of the game, then at least less late to the party.

Breeden sums it up neatly. “Embedding climate risk into financial institutions’ risk management is running ahead of private-sector disclosure.”