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BoE to assess changes for capital frameworks on climate risk

Bank of England building
The BoE says banks and insurers ‘need high-quality and comparable information’ about their counterparties’ climate risks. (Photo: Ben Stansall/Getty Images)

The Bank of England will carry out more work on climate change and regulatory capital frameworks for banks and insurers.

The Bank of England is to consider whether regulatory changes are needed to help banks and insurers manage climate risk.

In 2019, the Prudential Regulation Authority — through which the BoE regulates banks, insurers and investment firms — became the first financial regulator to set climate-related supervisory expectations for these companies.

It then published its “Climate change adaptation report” in 2021, pledging to request plans from companies that make insufficient progress on managing risks linked to climate.

On March 13, the PRA announced that it would investigate the need for further changes to regulatory capital frameworks, with regards to climate. The BoE pledged to promote better accounting for climate risks and back initiatives that help to improve climate disclosure.

“Existing capability and regime gaps create uncertainty over whether banks and insurers are sufficiently capitalised for future, climate-related losses,” it said. “This uncertainty represents a risk appetite challenge for micro and macroprudential regulators.

“Regulators, including the bank, need to form judgments on whether quantified and unquantified risks are within risk appetite, and act accordingly.”

EY sustainable finance partner Lionel Stehlin said: “Over the last decade, banks and insurers have increased their capital buffers and undertaken annual stress tests to prepare for a range of potential challenges.

“Across the industry, firms are operating at differing levels of capability to identify and manage climate risks as the economy transitions to net zero, and the bank’s analysis confirms that progress to address capability gaps is a priority, albeit a short-term one,” he told Sustainable Views.

Days before its latest announcement, the BoE had devised plans to rein in its spending on its climate work, according to Bloomberg.

Historic data is unhelpful

The central bank said that banks and insurers “need high-quality and comparable information” about their counterparties’ climate risks. This could include borrowers’ and policyholders’ exposures to climate-linked losses, it said.

The BoE noted that historic datasets are unlikely to be useful for predicting how climate risks could affect companies’ future losses, which makes modelling and calibrating capital for climate challenging.

It said that it would continue to consider how physical and transition risks could be built into baseline scenarios used for stress testing, such as government transition requirements over commercial properties’ energy efficiency.

In the US, the Federal Reserve is conducting similar work while taking a more tacit approach to climate. In January, its chair Jerome Powell said that the central bank would not be a “climate policymaker”.

The Fed is, however, carrying out a pilot climate scenario exercise that will see the six largest US banks assess the impact of scenarios — for both physical and transition risks linked to climate change — on assets within their portfolios.

“The Fed has narrow, but important, responsibilities regarding climate-related financial risks — to ensure that banks understand and manage their material risks, including the financial risks from climate change,” its vice-chair for supervision, Michael Barr, said in January.

Extending time horizons could have ‘unintended consequences’

in its 2021 report, the BoE considered whether the current typical, one-year time horizons for setting capital are appropriate for climate, with the potential for climate risks to materialise over a longer period.

While banking stress-testing frameworks regularly also consider time horizons of three to five years, the PRA, which supervises banks’ minimum capital requirements, said that it does not support changing these for climate risk, which it said would increase costs for companies. 

“Time horizons have been calibrated to provide time for firms to recapitalise following a loss,” it said. “It is not clear that firms would need longer to recapitalise for climate risks than other risks.” 

Lengthening these horizons would increase capital requirements for banks and insurers, as they would recognise risks earlier on in their frameworks. 

The BoE said that this could have “unintended consequences” for the net zero transition. Insurers could, for example, increase the “protection gap” for insurers, which refers to the difference between the amount of coverage that is purchased and the amount that is deemed economically beneficial.

It took the view that more work is needed to understand how banks’ Pillar 2 capital requirements — which represent a bank-specific requirement that sits in addition to its minimum requirements (known as Pillar 1) — should capture climate risks.

“The BoE’s approach feels quite incremental and cautious,” said Joseph Noss, senior director at consultancy WTW. 

Noss, a former BoE senior official involved with the central bank’s financial stability work, noted that based on the bank’s report, “we’re unlikely to see substantial increase in banks’ core (ie Pillar 1) regulatory capital requirements in the near term”. 

“The BoE finds that the Pillar 2 framework — more bespoke regulatory requirements that are tailored to individual banks — are a more appropriate tool to address gaps in regulation,” he told Sustainable Views. 

“One risk is that in forensically analysing the wood, the BoE ends up missing the big trees,” he said, adding that past financial crises “typically stem from a confluence of events, whose scale and correlation were previously thought to be implausible”. 

A service from the Financial Times