Bank Negara’s proposed climate risk regulation is a signal to financial institutions across Islamic markets to start to prepare

• Bank Negara Malaysia has an Exposure Draft open for comment through the end of March 2022 about how Malaysian banks and insurers will need to prepare for climate risks
• Modeled on the Basel principles for climate risk management & supervision, these show how quickly Islamic markets regulators may move on climate-related risks in the financial sector
• Financial institutions should expect a lengthy, complex but rewarding process to transform their risk assessment and management systems to cover climate risks and to build a culture that can respond to changes in how climate-related risks affect their businesses

Malaysia’s central bank, Bank Negara, will lead the way among Islamic markets with its climate stress testing and scenario analysis requirements, for which it has an open consultation. Part of the policy will come into force in June 2022 based on the Exposure Draft, with others phased in across 2023 and 2024. Some elements of the Exposure Draft align with the framework of the TCFD. They also build on the draft principles for climate-related financial risk management & supervision released by the Basel Committee on Banking Supervision in November 2021.

The elements of the regulations covering governance, strategy, risk appetite and risk management will enter into force by the end of 2023, while scenario analysis, metrics, targets and disclosures would follow with a deadline by end-2024. Starting in 2022, before the completion of the comment period for the Exposure Draft, the Joint Committee on Climate Change (JC3) will support scaling up of green finance and encourage capacity building in Malaysia’s financial sector.

The timeline for the phase-in of responsibilities for the financial sector is in keeping with the urgency of the risks that climate change poses. Although many of the mechanisms for the integration of climate-related risks into a financial institution’s existing systems may signal business as usual, the way that climate change impacts these institutions makes it anything but.

One of the first challenges that arise in addressing climate change relates to the data inputs required to analyze it. Emissions data are not typically available across a financial institution’s entire portfolio, so it is difficult to establish a starting point for risk levels and concentrations within a static financing portfolio. There have instead been efforts made to create ‘orders of magnitude’ estimates such as the one released by RFI Foundation for Malaysia in late-2020.

Among two of the recommendations we made in that report were for banks to systematically analyze their financed emissions to understand how susceptible they are to transition-related risks if those emissions were fully priced. The other is to take a proactive approach to nurturing customers to reduce their own GHG emissions. These elements are incorporated into the Exposure Draft’s coverage of the Strategy component of financial institutions’ response to climate-related risks:

“Climate-related targets are important to steer financial institutions into taking early actions in managing transition risks, including proactive and continuous efforts to manage the risk of economic dislocation. This may include developing transition strategies for customers over the long term, including the use of scenario analysis to assess the pathways of future emissions that would be financed by financial institutions.”

This is an important and particularly challenging issue for financial institutions to manage once they understand the emissions they (directly and indirectly) finance. One challenging aspect for most financial institutions, especially banks and insurers, is that they often cannot meet targets for financed emissions solely through removing their exposures to high-emitting sectors.

Beyond the challenges of exiting financing already on their books, banks and insurers know that reducing emissions through divestment alone doesn’t mitigate those emissions, it just shifts the problem to other banks, insurers, investors or other stakeholders. For example, as noted in the Exposure Draft, financial institutions changing their strategy to support the transition to a low-carbon economy have to “mitigate risks surrounding economic dislocation that may arise from the abrupt withdrawal of financing from economic sectors or activities that are vulnerable to climate-related risks, which may have potential adverse feedback loops to the wider economy and financial stability”.

This is a difficult challenge for financial institutions to surmount quickly. Even a phase-in period of 2 to 3 years may be challenging for banks to fully make the necessary changes, and is the reason why they need to begin as soon as possible and approach the challenges from many different angles. For example, one challenge they face is that the data they need to evaluate their (static) starting position are significantly lacking when compared to what they need to chart the (dynamic) path forward.

Financial institutions don’t need to just create static catalogues of their current exposures; they also have to evaluate how susceptible to physical and transition risks their financing assets are during a transition process where many different pathways are possible. This requires financial institutions bringing together many capabilities and formalizing them across their risk assessment, risk appetite setting, and risk management processes.

Bank Negara recommended for larger, more complex institutions that these responsibilities could be best handled with a centralized Chief Sustainability Officer, while leaving flexibility for smaller institutions to “ensure an integrated view of risks” and react to changes they cannot anticipate. Some of these changes will be ordinary-course corrections between different foreseen pathways that can be anticipated when policies are being drawn up.

Other changes will be sharp enough to up-end current expectations about climate-related financial risks, and financial institutions will have to respond dynamically. This requires more than just a technical approach to climate-related risk assessment and risk management to achieve ‘resilience’, which is the objective of the new regulations.

It requires capacity-building to understand how climate-related risks are manifest, but also institutional change to build in flexibility, to not expect that business as usual based on historical correlations will be enough to navigate the impact of climate-related risks on the way towards a low-carbon economy. Whether financial institutions centralize the functions of those charged with integrating climate-related risks across an institution or not, it will be of overriding importance for each financial institution to avoid allowing too much fragmentation or development of silos for different types of climate-related risks.

It is promising to see that the regulations start by requiring a gap analysis between current practice and the requirements of Bank Negara’s proposed regulation. Regular review of progress against the implementation plan developed from the gap analysis will be important. But in addition to this, the dynamic nature of climate-related risks makes it almost as important to supplement regulator-mandated gap analysis and supervision with an assessment from external stakeholders. An outside-in perspective may help to highlight otherwise unaddressed risks that begin to emerge during the multi-year implementation timelines contemplated in developing climate risk regulations in Malaysia and beyond.

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