David Swallow and Chris Faint
Policymakers have been investing heavily, to an accelerated timeline, to better understand the financial risks from climate change and to ensure that the financial system is resilient to those risks. Against that background, some commentators have observed that the most carbon-intensive sectors may be subject to the greatest increase in transition risk. They argue that these risks are not currently included within risk weights in the banking prudential framework and that regulators should adjust the framework to include them. Conceptually, this argument sounds credible – so how might UK regulators approach whether to adjust the risk-weighted asset (RWA) framework to include potential increases in risks? This post updates on some of the latest thinking to help answer this question.
The purpose of RWAs
To begin, let us revisit the purpose of RWAs. RWAs are a key component of the regulatory capital framework and are designed to reflect differences in risks across banks. Risk weights are set to ensure that banks maintain sufficient capital given their balance sheet risks. Broadly the idea is that assets with higher risk receive a higher risk weighting, so that capital requirements increase with risk. Banks use different approaches to calculate their credit RWAs. Some firms use a standardised approach, where the risk weights are defined within internationally set prudential standards, and others use their own complex internal models.
So how should we think about RWAs in the context of climate risks? Importantly, there is now broad agreement that climate change will create risks to the financial system that regulators should address. For example, the Basel Committee on Banking Supervision (BCBS) has set out a number of potential channels through which both physical and transition risks could arise across different sectors. If climate change might impact how risky certain assets are, then it follows that regulators would usefully consider whether there could be a material understatement of risk within the RWA framework, and if so, how to address it.
What steps would be required to change risk weights?
With this in mind, let’s think about some of the key steps that policymakers might consider when analysing whether there is a gap in the risk-weight regime to be addressed. We use credit risk in loans to sectors that might be subject to an increase in transition risk as an example.
Step 1: Determine the extent that the existing prudential framework already captures increases in credit risk from the transition.
A view is required on the extent that risks are already caught by the existing regulatory framework. This is a complex question to answer given the underlying nature of calculations. To illustrate this:
- Within both the standardised and internal model approaches, some aspects of credit risks are calibrated by historical data. Arguably, this might capture risks where transitions are already in progress (eg the phasing out of diesel engines) but not all new risks before they crystallise.
- There are also some forward-looking components such as the use of credit ratings, which might capture transition risks. External credit rating agencies may reflect the greater risks that a company in the carbon-intensive sector faces from climate change in their credit rating. This might then be used by a bank on the standardised approach as part of calculating their RWAs for credit risk.
- Firms that use internal ratings in their RWA calculations may also reflect a change of risk in their modelling. The ability of firms to do this will improve over time, as government policies on the transition to net zero are announced.
To add to this complexity, prior to taking any specific action, regulators might want to understand the extent that risks are captured today, and also how that might change over time. If regulators update risk weights today to compensate for risks that will get captured in due course, it could lead to the over capitalisation of that exposure.
Step 2: Determine the time horizon over which to consider the risks.
The existing credit RWA framework is generally calibrated to mitigate against unexpected losses over a one-year period. It could be argued that this is a less appropriate time horizon for climate risks, which will likely continue to grow throughout, and beyond, the period.
Taking the broader framework as it stands, if policymakers were to change the time horizon over which climate risks are reflected in RWAs, they should reconcile how that would be coherent with the broader framework. This point is subject to a live debate.
If a longer time horizon was used, the likely increasing nature of climate risks may imply a greater potential increase in credit risk. Furthermore, as risks build across different sectors over different time horizons, this decision would also affect which assets and sectors would face increased risks. The longer the time horizon is, the more complex this analysis is likely to become.
Step 3: Determine which risk weights to change and how to calibrate them.
Regardless of the horizon used, it would be important to understand how credit risk might change over time. Forming a view of this is complicated as the impacts of climate change and timings of transition pathways are highly uncertain. For example, short-to-medium term transition risks in some high-carbon energy assets look materially lower today than they did a year ago. Therefore, regulators would likely look for a higher degree of certainty over the future path of risks before interjecting to reflect them.
Given this uncertainty and the lack of historical data, any views of risks would likely require the use of scenario analysis. Policymakers would have to decide on the most appropriate climate scenario to use for this analysis. Key decisions would be on the path of the scenario and also the level of stress embedded within its calibration. For example, results would materially differ if a delayed transition scenario was modelled over an instant transition scenario. As valuable as the scenarios provided by groups such as the Network for the Greening the Financial System are, their long-term reference scenarios are unlikely to be appropriate for this analysis, so new scenarios would be required.
The toolkit that would allow regulators to undertake this analysis is still being developed. This analysis might become more tractable over time as government policy becomes clearer and uncertainties reduce, but that might not be imminent.
Returning from the conceptual to the real world
The question of climate risk weights and whether to take further regulatory action is tricky and arguably unprecedented. It is therefore positive that the international regulatory community is actively discussing the links between climate change and the capital framework, including through the BCBS Taskforce on climate-related financial risks.
Some may argue that the steps above are too arduous, and that regulators should cut through this uncertainty and adjust risk weights for those sectors most exposed to transition risks now. But there are consequences to policymakers’ actions and it is therefore important to work through them carefully with reference to their mandates. For example, the Prudential Regulation Authority (PRA) remit requires it to also consider impacts on competition and energy security.
In the meantime, should regulators be worried that banks may be undercapitalised against the risks of climate change? The risks of climate change could be material and they will increase unless early, well-managed action is taken to reduce greenhouse gas emissions. But in the absence of a sudden shock and on the basis of existing modelling assumptions, emerging evidence from international exercises so far suggests that banks are unlikely to face significant losses in the very near term. This is not a given, but it suggests that time exists to better explore the steps set out above. In the meantime, banks are building up their risk capabilities in response to the PRA’s supervisory expectations.
It is clear that a better understanding is needed of how banks’ risk weights will change as transition risks from climate change build over time. This post sets out some of the steps relevant to answering this question. Given the current time horizon over which capital is set, the uncertainty of transition risks over those horizons and the results of regulators’ published analysis – the argument for regulators to apply a compensating adjustment to risk weights now looks challenging. Should the argument become persuasive, further analysis and tools would be required to calibrate any regulatory adjustment.
Developing a better understanding of climate risks is important. For that reason, domestic and international groups are investing heavily to improve their understanding. In the meantime, we note that RWAs are just one part of the capital framework. It is therefore important for policymakers to think about the capturing of climate risks holistically, across all policy levers available.
What is also clear, is that there are many open and important questions to consider as policymakers push forward with this important agenda, a number of which will be discussed at the Climate and Capital conference on 19 and 20 October 2022.
David Swallow and Chris Faint work in the Bank’s Climate Hub.
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