The FSB outlines a roadmap to address key climate risk management tools for regulators

  • A comparative analysis between regulatory responses to climate-related financial risks shows how the issue is permeating regulation of financial institutions outside of developed markets
  • The global to-do list to create regulatory tools on climate is long and still growing, but is translating into policy changes that are already impacting financial institutions
  • Although regulation continues to evolve and develop in the area of climate risk, financial institutions need to start responding now to benefit from the feedback loop and build their own internal capacity

The “Inevitable Policy Response” (IPR) advanced by the UNPRI and others, which the RFI Foundation has frequently highlighted and has driven our exploration of financed emissions risk in Islamic markets, is moving rapidly in the lead-up to COP 26. The IPR translates long-term changes to address climate change into near-term policy expectations. It proves useful at taking 2030 climate targets and preparing for what to expect from regulatory and supervisory policy in the 2021–2023 timeframe.

Previously, we highlighted one realization of IPR in the ‘substantial investment’ that Bank Negara Malaysia (BNM) had asked the country’s financial institutions to make in climate-related risk management capacity. The financial institutions were being asked to follow the regulator’s lead after they announced a path towards mandatory climate-related financial risk disclosures and stress testing as well as their exploration of using the Pillar 2 supervisory review to possibly increase supplemental capital requirements on financial institutions failing to keep pace on climate risk management.

In comparison to what the Financial Stability Board outlined in its new Roadmap for Addressing Climate-Related Financial Risks, what Bank Negara was announcing represented the global consensus among regulators, not a departure from it. For other financial institutions based in or operating within Islamic markets, the expectation should be that other central banks will take similar actions, more likely sooner rather than later.

The Roadmap “focuses most specifically on actions in the short and medium term (2021–2023), but also indicates the direction and goals of work beyond that time period”. In keeping with the comparison point to Bank Negara’s announcement at the JC3 Conference as indicative of what regulators in other Islamic markets have adopted or are considering, it is useful to take a comparative approach beginning with disclosures, risk management and systemic risk oversight and responses.

The starting point for central banks is that data and disclosures are lacking. Bank Negara Governor Nor Shamsiah has outlined steps to “identify and address critical data gaps in climate and environmental risks-related information [because] without adequate and good quality data, we will not be able to make informed assessments and judgments […] for climate risk management, disclosure and scenario analysis.”

The FSB roadmap comes from the perspective of “the information needs of, and actions by financial regulatory and supervisory authorities (both nationally and internationally) to promote financial resilience to climate-related financial risks.” It is planning an interim report release in October surveying regulatory and supervisory approaches to addressing climate risks, including an international stocktake of different approaches. Many national financial reporting organizations are moving in the same direction — in the UK for example, the Financial Reporting Council released a report on its plan to address ESG challenges, including climate change.

One way that the FSB is offering support in this regard is the work of the IFRS Foundation on global sustainability disclosure standards, starting with climate, where draft standards are expected in the first half of 2022 and final standards in the third quarter. Overlapping that time period, based on Bank Negara Governor Nor Shamsiah’s speech, the Malaysian central bank will determine the process by which financial institutions will face mandatory climate risk disclosure, likely making use of the Principles-based Taxonomy and TCFD recommendations.

But regulators such as Bank Negara and other pieces of the international financial architecture such as the FSB don’t see data and disclosures as sufficient for the financial stability concerns that climate change raises. Nor Shamsiah put it this way: “We know that it will take some time before we see greater uniformity in approaches and while we would prefer not to dictate practices, we see a clear need to reduce the substantial divergence currently observed across institutions. The Bank is exploring various options to encourage better risk management approaches by outlier institutions — including through Pillar 2 capital requirements and supervisory assessments to reflect an inadequate consideration of climate risks.”

Others such as Pierre Monnin at the Council on Economic Policies have said these types of risk responses should be available to regulators through systemic risk buffers rather than via Pillar 2 supervisory review. Although the mechanics would be different, the result would be similar in requiring stronger risk management and higher capital for financial institutions, with more exposure to regions or sectors with higher climate risk or those that have weaker risk management capabilities.

This would similarly target a segment of the market rather than every institution. In the European context, “more than 70% of the banking system credit exposures to the identified high-risk firms are held by only 25 banks, while their total assets represent 64% of the banking system”.

In either case, there is a need to apply the better data and disclosures by financial institutions with improved modeling of the financial impacts of various likely scenarios. In the case of Malaysia, the improved analysis through a stress test would be developed over a four-year period. On the global level, the action is more rapid.

The FSB outlines that efforts to develop forward-looking metrics are underway or planned at NGFS, the IMF and the FSB, and are scheduled to be completed in 2022. At the same time, the Network for Greening the Financial System (NGFS) has released two macroeconomic scenarios already, while the IEA has released one for the energy sector. Other efforts are improving the practices around scenario analysis. The FSB acknowledged that “given the importance of a long-term, forward-looking perspective, further deepening of scenario analysis, making use of NGFS scenarios, will be important.”

All in all, the many threads of ongoing work to address climate-related risks can be overwhelming. There are so many different regulators, standard setters, international organizations and others contributing to parts of what is developing around climate risk management in the financial sector. From a financial institution perspective, it can be tempting to wait until a specific regulatory mandate comes down and then begin implementing.

One comment from the FSB’s roadmap, and the comparative overview between what Bank Negara has announced and the global roadmap from the FSB, should raise the value of starting work now instead of waiting. The regulators are not all going this alone; there is a recognition that no single country, institution or regulator has the capacity to put everything into action after the regulations are written.

They concluded that “feedback and learning across areas is therefore an integral part of developing effective policies to address climate risk. For instance, it is critical to feed back experiences with the analysis of climate-related vulnerabilities, including scenario analysis, into efforts to fill data gaps and data collection. The same applies to experiences with the regulation and supervision of climate-related risks and the design of scenario analysis”.

A financial institution could add onto this prognosis the integral role in capacity development for each financial institution from feedback. They will be able to address climate-related risks much better as a result of promoting as much feedback as possible both internally and through collaborative efforts with peer institutions, multidisciplinary startups working on climate finance, and NGOs focused on tackling the biggest responsible finance challenges yet to come.

Republished from the RFI Foundation’s weekly newsletter. Subscribe for free here!

Linking responsible finance & Islamic finance. CEO, @RFIFoundation.