Climate change risk managment

An Introduction to Climate Change
Risk Management in Banking
January 2022
Professor Moorad Choudhry
Faculty BTRM

LinkedIn video series 2
© 2022 BTRM /Moorad Choudhry
The risk exposures of a financial
institution are myriad and complex…
Credit risk Market risk Strategic Risk
Liquidityrisk Funding risk Reputational risk Legal risk
ALM Risk
© Suborna Barua, University of Dhaka & Bangladesh Institute of Capital Market 2021. Used and adapted with permission.

Climate change risk is now one of them…
Managing “Climate Change Risk” at a bank is a multi-dimensional discipline
3
© Suborna Barua, University of Dhaka & Bangladesh Institute of Capital Market 2021. Used and adapted with permission.

“Tone from the top….”
 Climate change, left unchecked, will lead to irreversible harm for
generations to come….If the previous decade was marked by a “call to
action”, then this coming decade must answer it….And the financial
sector should be instrumental in driving that change.
 Sarah Breeden,Executive Director, Supervision, Bank Of England, July
2020
 Leaving aside this statement per se, it is clear that banks must address
“Climate Risk” and “Climate Change Risk” from a multi-dimensional
perspective, namely:
 Policy on “climate change” and climate change risk management
 Strategy incorporating this policy
 Tactical approach implementing this policy
 Customerorigination approach
 Balance sheet risk management approach
 Regulatory compliance

Climate change risk agenda
 In essencebanks are obliged – word used deliberately – to state, and be seento
follow, a Board-level approved Climate Change Risk policy
 Draft and Board-review a template “Environmental and Sustainability Policy
 There are three drivers of this:
 Regulatory compliance: the BCBS, EBA, PRA and other supervision authorities have
pronounced on this so banks are obliged to demonstrate compliance with published
“guidelines” (Session II)
 Market expectations: a large majority of customers, institutional shareholders and other
external stakeholders are “on side” with respect to “climate change” and will expect their
bank to be proactive in this space
 Business opportunity: there may be growth- and RoC-related benefits associated with
adapting existing and/or implementing new products and services that address the global
economy’s shift to more “environmentally friendly” business
 From a practical management-level and operational perspective,the imperative is
to assess,understand and apply what all this means for a bank’s risk
management framework (RMF)

Climate change risk agenda…
 “Climate change” and “climate risk” should be viewed from at least
three related, but distinct, viewpoints:
 Physical risk (see forthcoming slide):actual impact on environment and
impact on customers,suppliers,etc.
 Eg., flood,forestfires,extreme weather events
 Gradual change to climate (rise in sea level, etc)
 Transition risk(see next slide): change in operating modelas global
commerce moves to “carbonneutral” products and services.Impacton the
bank’s customers and hence impact on bank:
 Reputational risk
 Policy & legal risk
 Market risk (asset values, collateral values)
 Firm-specific reputation riskand balance sheetliability risk
 Perceived contributionto climate change
 Failure to implementcommitments under global climate agreements
 Fiduciary duty

More tone from top…
 The “Climate Risk” obligation is part of the wider “ESG” agendanow in play at
banks (and other corporates)
 [BTW - ESG itself is turning into “ESGID” as “Inclusion and Diversity” are added
to this discipline (author’s preference over the term “Diversity and Inclusion”)]
 Examples of directionfrom regulators:
 EU: Sustainable Finance Action Plan to embed sustainability concepts into the financial
system, includes Low-Carbon Benchmarks Regulation, Sustainable Finance Disclosure
Regulation, and amendments to existing EU regulatory frameworks (e.g. MiFID II,
AIFMD, UCITS)
 UK: PRA Supervisory Statement in 2019 (see Session II); Green Finance Strategy aims
to embed sustainability into mainstream finance. FCA is consulting on corporate
disclosure of climate risks and on “greenwashing”; Bank of England to introduce stress
testing of climate change as part of its biennial exploratory scenario
 Germany: BaFin published guidelines in Dec-2019 for banks on managing ESG risks
including climate risk
 Australia: SEC published guidance in 2019 on incorporating climate risks into existing
reporting disclosure requirements
 Singapore: MAS has published guidance on incorporate climate-related risks into banks’
stress test scenarios

The BIS and climate change risk
measurement approach
 The BCBS published
Climate-related financial
risks – measurement
methodologies in April
2021
 It’s a riveting read… ☺

BCBS Paper: highlights
 Five key findings (direct quotes):
 First, climate-related financial risks have unique features, necessitating granular and
forward-looking measurement methodologies.
 Second, to date, measurement of climate-related financial risks by banks and
supervisors has centred on mapping near-term transition risk drivers into counterparty
and portfolio exposures.
 Third, banks and supervisors have predominantly focused on assessing credit risk, as
they advance in applying methods to translate climate-related exposures into categories
of financial risk.
 Fourth, while banks and supervisors remain at an early stage of translating climate-
related risks into robustly quantifiable financial risk, work continues to gather pace.
 Fifth, key areas for future analytical exploration relate to measurement gaps in data and
risk classification methods, as well as methodologies suitable for assessing long-term
climate phenomena not always of a standard nature. On the side of measurement,
assessing climate-related financial risks will require new and unique types of data – not
necessarily the same as those banks have traditionally used in financial risk analyses –
spanning three areas: data translating climate risk drivers into economic risk factors; data
linking climate-adjusted economic risk factors to exposures; and data to translate climate-
adjusted economic risk into financial risk.

Example of regulator guidance: UK PRA
 The PRA’s approach to regulating climate risk is in line with Basel
guidance (BCBS239) in its principles-based approach but should evolve
into specific detailed guidance as banks gain experience in this type of
risk management, related stress testing and business model adaptation
 Guidance to date:
 April 2019,SS3/19 BoE supervisorystatement Enhancingbanks’and
insurers’approaches to managingthe financial risksfrom climate change
 July 2020,“Dear CEO” Letter
 Dec 2021,SS3/19 date by which compliance,proportionate to nature, scale
and complexityof the business is expected
 2050,Net Zero Emissions:Managing climate risk would be (should be) as
orthodoxto a bank’s business as would be managing creditor market risk
 Note managing“climate risk”,which the authorinterpretsas
managing the risks associatedwith climate changeand the response
to perceivedclimate change by a bank’s customers and stakeholders

Regulator expectation
 The PRA’s supervisory statementSS3/19 requires financial firms to respond to
the financial risks from climate change proportionate to the nature, scale, and
complexityof its business,with expectedimpacts in these areas:
 Governance: Board level oversight; a risk appetite statement that covers long- and
short-term risks; Clear roles and responsibilities; SMCR ownership; Relevant skills
and expertise
 Risk management: Evidence climate risk management in place in existing
frameworks; Use of scenario analysis and stress testing to inform risk identification;
Integration into ICAAP; Develop quantitative and qualitative tools, metrics and MI for
monitoring climate risk; Evidence credible mitigation and diversification; Engage with
clients, consortia and data providers to acquire needed data
 Scenario analysis and stress testing: Informs strategic planning and impacts the
overall risk appetite and business strategy; Addresses a range of outcomes through
short- and longer-term assessments of different transition paths to a low carbon
economy; Informs the management actions and mitigations of financial risks;
Incorporated into ICAAP
 Disclosure: Included in Pillar 3 • Consider addition transparency; Actively evolve
disclosure; Engage in wider climate-related initiatives; Encourage in clients and
wider economy
 All UK banks must have fully embeddedtheir climate risk frameworks by 31-12-21

Responding to supervision guidance
 Recognisethe impact to the RMF, to risk measurementand to reporting
 In theory at least, all risk disciplines are impacted by climate change risk For
example;
 Market risk: natural disasters and/or climate policy changes leading to the re-pricing of
financial instruments, including equities and bonds (although to prevent cynicism we
should note “natural disasters” have been recorded throughout recorded human
history…)
 Credit risk: potential increases in defaults by businesses and households due to extreme
weather events; climate events causing collateral depreciation
 Liquidity risk: climate-related risks adversely affecting refinancing opportunities;
increased liquidity requirement to manage impact of climate risk
 Operational risk: supply chain disruptions and facility closures as a result of physical
risks; broader business resilience problems and the associated effect on brand
reputation
 Reputational risk: environmentally conscious customers taking their business elsewhere
if firms are perceived as not doing enough; company stock prices falling due to loss of
brand value
 Addressall three lines of defence
 Climate change risk management should be embedded across the 3LoD model

My climate risk management framework
 My suggested 9-part climate change risk approach embedded in the bank’s RMF:
 Risk Strategy: define bank’s overall philosophy and objectives and decision on whether appropriate to
support clients and counterparties meeting net-zero emissions by 2050 and how to manage those that are
more heavily impacted and transitioning away from previous op model
 Risk governance and frameworks: set out clear roles and responsibilities for senior executives (SMFs)
and committee ToRs explicitly referencing climate risk.
 Risk policies and standards: climate risk strategy are embedded into control objectives, principles, core
requirements (Risk Policy) and key controls and ownership (Risk Standards).
 MIRA (see Seminar 1) and risk Identification: climate change included within risk register and risk
taxonomies. Financial, reputational and CSR risks from climate change identified separately. Top-down
and bottom-up processes developed for identification of emerging risks.
 Risk Measurement, Appetite and Limits: quantify exposure to physical and transition risks and calibrate
the “green zone” level of risk which the bank is happy to accept. Develop models and data analytics
approach.
 Identify and execute strategies: adapt client origination and credit reviews, assess impact on capital and
RWAs, identify climate risk mitigation opportunities.
 Specific pricing for climate risk and introduce climate related loan and deposit products
 Monitor exposures: develop a consistent, reliable set of climate risk indicators (KPIs ‘ KRIs) to support
decision making and monitor progress against climate related strategic aims and risk exposures to
appetite. Develop early warning indicators (EWIs) to ensure triggering management action when
necessary
 Review and measure performance: develop climate scenarios along lines of BoE’s biennial exploratory
scenario (BES) for climate change and include in ICAAP stress testing
 Disclosure

Climate risk and ICAAP Principles
©
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 Enshrine climate-risk governance within the RMF
 The Board should drive climate-risk governance.
 Nominate an SIF responsible for climate risk: typically the CRO
 Incorporate into stress testing:
1. Scenario analyses and stress tests should incorporate climate change impacts, as part of
the steps helping banks assess their resilience.
2. As part of the RAF review, identify specific relevantclimate hazards and primary risk
drivers by industry, which analysis can be used to generate physical and transition-risk
scenarios.
3. This enables banks to estimate the extent of damage caused by events such as floods,
droughts and heat wave driven forestfires (for example)
4. Quantify the impact by counterparty and in aggregate on a portfolio basis
5. Designand draft appropriate range of potential mitigants and put in place systems to
translate test results into an overview of the bank’s position.
6. Because the regulator will be prioritising stress testing in this space,it may be necessary
to acquire necessaryclimate-modelling expertise and required climate-hazard and asset-
level input data

“BAU” – the RAS daily MI
 Key Risk Indicators to be added to the daily / weekly / monthly KRI
dashboard
 This is presented in my standard template Risk Appetite Statement
(RAS) format

Executive
Responsible
Indicator Red Amber Yellow Green Rationale Comments RP
(EBA)
Strategic Risk Customer Loan Balance (variation
to budget)
>+/-10% >+/-5% > +/-2.5% < +/-2.5% Finite appetite for lending
Customer Deposit Balance
(variation to budget)
>+/-15% >+/-10% >+/-5% <+/-5% Finite appetite for deposit
taking
Pre-tax RoC TBC TBC TBC TBC *
Capital Risk Absolute Excess Over Total Capital <25bps <50bps <75bps >75bps Ensures the bank maintains
a level of capital above the
regulatory minimum
Common Equity Tier 1 capital
requirement
<70% <72.5% <75% >75% Ensures that a minimum
portion of capital is high
quality CET1
Leverage Ratio <3.5% <3.75% <4% >4% *
Climate Change Risk
KRIs and KPIs
Mixed Recycling 500 TBC TBC TBC
Paper (Confidential waste) 1500 1250 1000 900
Energy Efficiency - % of property loan
book with EPC ratings A-C
<35 <40 <50 >50
Flood Risk - % of property loan book
rated High Risk
>15 >12 >10 <10
Top 20 exposures with high ESG
exposure profile
TBC TBC TBC TBC
Share of lending to "High Risk" ESG
borrowers
>30% >25% >20% <20%
Trees Saved* over 12 months (#) <20 <25 <35 >35 *
CO2 Tonnes* saved over 12 months <1 <3 <5 >5 *
KWH Energy produced TBC TBC TBC TBC
Recycling rate TBC TBC TBC TBC
Illustration: incorporating example KRIs into RAS (w.i.p.!)

So we conclude
 From the bank’s perspective, we wish to:
 Understand what the external environment means forus, and forour
customers and other stakeholders
 Formulate the bank’s Policy on ESG – incorporating climate change risk –
and approve at Board level
 Addresswhat this means for bank strategy and customerorigination
policy
 Addresswhat this means for the bank’s operating model
 Addresswhat this means for our reporting and disclosures (this includes
both regulation and also “PR” angle
 Addresswhat this means for the bank’s RMF
 Embed the revised RMF into “BAU” processes
 Assess and understand what impacts may be expected at the operating
level

DISCLAIMER
The material in this presentation is based on information that we consider reliable, but we do not
warrant that it is accurate or complete, and it should not be relied on as such. Opinions expressed
are current opinions only. We are not soliciting any action based upon this material. Neither the
author, his employers, any operating arm of his employers nor any affiliated body can be held liable
or responsible for any outcomes resulting from actions arising as a result of delivering this
presentation. This presentation does not constitute investment advice nor should it be considered
as such.
The views expressed in this presentation represent those of the lecturer in his or her individual
private capacity and should not be taken to be the views of any employer or any affiliated body,
including any bank that employs any member of the BTRM Faculty, or of the lecturer as an
employee of any institution or affiliated body. Either he/she or his/her employers may or may not
hold, or have recently held, a position in any security identified in this document.
This presentation is © BTRM / Moorad Choudhry 2022. No part of this presentation may be
copied, reproduced, distributed or stored in any form including electronically without express
written permission in advance from the author.

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