Climate and capital: three key messages for banks and insurers from the Bank of England

Climate and capital: three key messages for banks and insurers from the Bank of England

Key points

• The Bank of England (BoE) has published its latest thinking on climate and capital.
• Ensuring that firms improve their climate risk management capabilities remains the near-term priority.
• The BoE is unlikely to pursue significant revisions to the Pillar 1 frameworks for banks and insurers, and considers that the current time horizons in the frameworks do not need to change.
• Climate stress testing will play a key role in future, but will need to evolve. Future supervisory exercises will explore risks not covered in the CBES (such as trading or litigation risks), and will likely assess risks over a shorter time horizon.

This week, the BoE published a report on climate-related risks and regulatory capital frameworks, following up as promised on the conference it held last October. The report does not include any new policy announcements, but does provide an update on the BoE’s thinking and signals several areas of future work that could eventually have an impact on banks and insurers in the UK.

We published a blog in October setting out our view on the direction of travel for changes to rules requiring on the capitalisation of climate risks in the UK, EU and at the international level. The themes and ideas explored in that blog are consistent with the Bank’s latest publication – you can read the blog here.

Nonetheless, there are three key messages worth taking away from this new report – in particular for heads of capital planning and risk officers who are following this topic closely.

What we learned from the Bank’s latest report

First: Fostering improvement in firms’ risk management capabilities remains the near-term supervisory priority (rather than capital).

This will not be news (by any stretch of the imagination) to firms, but it will shape the Bank’s next steps. For example, the Bank has made clear that there will not be another Climate Biennial Exploratory Scenario (CBES)-style exercise in the short term, to give firms time to fully embed supervisory feedback from the previous exercise.

One of the key questions that the Bank is seeking to answer is the scale of undercapitalised climate risks in the UK financial system, and whether it is willing to tolerate those risks. While it has not yet reached a definitive answer, it sees improved risk management by banks and insurers as an important tool for reducing the quantum of required additional capital. In other words – the more effective firms’ risk management is, the less need there is to address any shortcomings that might exist in the current capital framework.

Improvements to banks’ and insurers’ ICAAPs/ORSAs is key. The Bank reiterated the point that firms ICAAPs and ORSAs should provide supervisors with sufficient comfort that they are holding enough capital in light of the climate risks that they face over their capital planning horizon. We explored last year how supervisory expectations for the ICAAP and ORSA will evolve.

Second: Climate stress testing will play a key role going forward, but will need to evolve.

While the Bank has said it will not launch a concurrent climate risk stress test in the near term, it has indicated that future exercises will look to explore risks not covered by the first CBES. For banks, such an exercise would likely focus on trading book exposures. For insurers, the PRA has previously indicated its intention to further explore contract certainty in the context of climate litigation risk through its regular biennial stress tests.

Furthermore, although there will be no near-term concurrent stress testing exercise, the Bank emphasises that it expects firms to demonstrate improvements in their internal capabilities for stress testing and scenario analysis, including through ICAAPs and ORSAs.

The Bank will also consider how in the medium term to use climate scenarios for setting capital. This implies in fact a shift to a ‘stress testing’ approach, potentially using shorter and more severe scenarios. One idea mentioned by the Bank is to incorporate the impact of already announced government transition policies into its stress test scenario.

The Bank’s interest in exploring this approach is consistent with developments elsewhere. The Network for Greening the Financial System is developing short term scenarios, while in the EU the ESAs recently received a mandate from the Commission to run a cross-sector, short-term scenario analysis exercise. There are also industry-led initiatives underway (one of which is being jointly coordinated by Deloitte and the International Swaps and Derivatives Association (ISDA)) developing shorter-term climate scenarios, with particular focus on the trading book.

Third: Revisions to the time horizons of the Pillar 1 framework are unlikely for now.

The Bank makes clear that it considers that the time horizons covered currently by the bank capital framework (generally one year in Pillar 1, and three to five years in Pillar 2 stress testing) are sufficient – at least for calibrating capital requirements. It highlights that a more forward-looking approach could also potentially be incorporated through the use of external credit ratings and accounting (including expected loss accounting under IFRS9).

This view is one shared by the BCBS, which published FAQs outlining a wide range of areas where climate risks should be captured in the Pillar 1 framework (without any changes to applicable time horizons). We expect that EU supervisors will come to a similar conclusion when the EBA publishes its own report later this year – although the upcoming CRD6 package will require EU supervisors subsequently to evaluate a longer time horizon (of 10+ years) in the SREP, so the topic of time horizon is not being taken off the table for good.

The Bank also does not propose any changes to the time horizons in the Solvency II regime for insurers, and broadly concludes that early work suggests that the Solvency II framework’s relative flexibility should support the ability to capture climate risks. The Bank will, however, continue to evaluate the extent to which the Standard Formula and Matching Adjustment adequately capture climate risks over time.

Next steps for firms

No news does not mean that firms have nothing to do. The relative clarity this report provides on the direction and pace of progress of Bank’s requirements for capital and climate enable firms to focus on a concrete set of near-term priorities – such as improving climate risk identification, measurement and management capabilities, and understanding the risks that might arise as banks execute their transition plans.