Taming the green swan: Asia Pacific prudential regulation in the face of climate risks

January 26, 2023|Written by , and |Bank of Korea, Hong Kong Monetary Authority, Monetary Authority of Singapore, Bank Negara Malaysia
A close-up of a black swan, head and neck curved over its body
A green swan is the environmental equivalent of a black swan event – an unforeseen, low-probability event that has significant impacts © David Clode

This is the second article in a series examining how Asia Pacific central banks are responding to the climate crisis – read the first article.

The story on climate is clear: there needs to be a comprehensive policy response in order to transition to a low-carbon economy. This is true for Asia Pacific in particular, as the region may experience more severe impacts from climate change compared to others.

Without these policies, the region could be exposed to green swan risks – rare, unexpected events with extreme impacts which could trigger the next systemic financial crisis. Central banks have a big role to play in avoiding this outcome.

An essential part of this is ensuring the financial system adequately manages climate-related financial risk, among others through prudential regulation to ensure the safety and soundness of financial institutions and to safeguard the stability of the system. The integration of risk-based climate considerations in the prudential rules for banks, such as capital and liquidity requirements, could contribute to strengthening their risk management systems and ultimately their resilience to climate-related shocks.

The direction of travel has also been set by the Basel Committee on Banking Supervision (BCBS), the main global standard setter for prudential regulation through its recently published principles for effective management and supervision of climate risks. It recommends, among other things, that banks should identify and quantify climate-related financial risks and incorporate material risks in their internal capital and liquidity adequacy assessment processes.

Within this area, supervisors have a great opportunity to improve and to set precedent for taking climate into consideration in capital and liquidity management so the financial implications of climate risks are adequately understood and embedded.

Using the latest results from WWF’s Sustainable Financial Regulations and Central Bank Activities tracker (Susreg), we can assess how Asia Pacific countries are performing on climate-related prudential regulation, focusing in on indicators related to microprudential as well as macroprudential supervision.

Microprudential supervision

Integrating climate considerations within microprudential frameworks would safeguard the safety and soundness of individual financial institutions against climate-related financial risks. The Susreg framework assesses how well banks have performed in three areas (see figure 1):

  • considering how climate risks and opportunities impact banks activities and integrate these considerations into their overall business strategy and governance. This includes setting up effective corporate governance, factoring in long-term horizons, and implementing climate risk management principles as recommended by the BCBS;
  • developing capabilities to understand the impact of climate risk drivers on all financial risks and to incorporate these considerations within the banks’ policies and processes, as well as risk management and control processes;
  • Develop a robust understanding of portfolio risks and impacts, including exposure to climate risks and the extent of its negative impacts as well as set science-based targets in line with the Paris Agreement.
Table showing how Asia Pacific countries have performed on prudential supervision
Figure 1: fulfillment of indicators on supervisory expectations towards banks (microprudential policy) on select topics based on the Susreg framework © WWF

Across Asia Pacific, progress on supervisory expectation is quite fragmented on climate-related issues. Singapore is leading in this respect, thanks to its guidelines for banks on environmental risk management  issued by the Monetary Authority of Singapore, which outline a more comprehensive set of supervisory expectation for banks in managing climate-related risks. The Association of Banks in Singapore has also released a set of questionnaires for banks to use with clients to assess and mitigate their environmental risks.

Elsewhere, the Hong Kong Monetary Authority (HKMA) has also drafted a set of guidelines consistent with the recommendations from the Task Force on Climate-related Financial Disclosures and expect financial institutions in the country to make their first disclosures by 2025 at the latest.

Microprudential expectations on capital and liquidity have received little attention in Asia Pacific countries (see figure 2). Most jurisdictions have not put climate considerations into their microprudential framework, including minimum capital requirements and liquidity ratios.

At the moment, only Malaysia covers most of the Susreg microprudential indicators, including a requirement for banks to incorporate  climate risk impacts into the calibration of liquidity ratios, the internal capital adequacy assessment process (ICAAP), minimum capital requirements, and overall liquidity risk management process. However, only a partial score was given since the regulation had not come into effect at the time when the assessment was conducted.

Bar chart showing level of Asia Pacific performance on microprudential supervision
Figure 2: regulatory performance of Asia Pacific countries on rule-based microprudential expectations using Susreg climate-specific indicators © WWF

In terms of enforcement, authorities in Hong Kong and Australia expect banks to incorporate climate considerations in their liquidity risk management process, while banks in the Philippines have been asked to integrate climate considerations in their ICAAP.

Macroprudential supervision

Focusing on the stability of the financial system as a whole, macroprudential supervision is critical in identifying system-wide imbalances in order to regulate and mitigate these risks. Examples of these system-wide aspects include fire-sale dynamics, a credit crunch, and an increase in insurance premiums and in the insurance protection gap which could affect credit risk for banks.

Most jurisdictions consider climate-related risk at least in one macroprudential indicator, except for India and Indonesia (see figure 3). In most cases, this is in the form of stress tests, which have been conducted in China, Hong Kong, Japan and South Korea. Stress test initiatives have been announced in other countries such as Malaysia, Australia and the Philippines but are yet to be implemented. South Korea leads in this respect, publishing a comprehensive stress test report which estimated the impact of transition risk on  GDP and the capital adequacy ratios of domestic banks.

The HKMA pilot climate risk stress test showed that the expected credit losses of the banks’ exposures directly affected by climate change, such as residential mortgages and lending to high-emitting industries, are projected to increase sharply.  The capital adequacy ratio of the domestic systemically important authorised institutions will drop by 3% on average over a five-year horizon under the disorderly transition scenario.

On the other hand, no supervisors in the region have released prudential rules to limit the exposure of banks to certain activities based on climate-related consideration, which would prevent and protect against the build-up of systemic risk.

Recommendations

To fully adapt prudential regulations to meet the challenges posed by climate change, central banks and financial supervisors need to set goals to guide their actions over the short, medium, and long term. In the next three-to-five years, financial regulatory instruments should require banks lending companies on the “always environmentally harmful” filter list to set aside regulatory capital for the full lending amount. All assets of companies and projects from sectors on the list should no longer be considered liquid, and should therefore be excluded in calculating banks’ net stable funding factors and liquidity coverage ratios.

Bar chart showing levels of Asia Pacific macroprudential supervision by country
Figure 3: regulatory performance of Asia Pacific countries on macroprudential supervision using Susreg climate-specific indicators © WWF

Central banks and financial supervisors should continually assess the exposure of banks to the “always harmful” list, and set credit ceilings and exposure limits, such as credits in those companies not exceeding 5% of the total loans, as well as capital add-on if exposure is not adequately reduced. A sufficiently high sector-leverage ratio of between 50 and 100% for exposure to the list can also have a steering effect. Those banks subject to existing systemic risk buffers should face increased rates according to their exposure to companies on the list, or to assets in particularly vulnerable regions.

In the initial stages, data collection efforts could focus on qualitative information with the aim of filling significant data gaps such as risk measurement of relevant risk categories, risk reduction measures that will affect exposures, and counterparties’ information (such as decarbonisation plans and business strategies) in the region.

As data used to analyse these risks mature over time, efforts can be channeled into measuring financial risk exposures, asset location at a granular level, and financial impact and forward-looking metrics. These can include portfolio alignment, decarbonisation pathways, implied temperature rise, and climate value-at-risk to assess tail risks.

A longer time horizon of 10-30 years should be applied when calibrating capital requirements to not only capture climate-related financial risks to banks themselves, but also the adverse impacts they cause, also know as double materiality. Future scenario analysis and stress test exercises should also consider the range of financial risk beyond credit and market risk, such as liquidity and insurance or underwriting risk, which could be pivotal to addressing the interconnectedness of sectors across the financial system. These scenarios should also integrate likely or probable physical tipping points, such as the melting of the Greenland ice cap or disintegration of the West Antarctic ice sheet.

Cooperation between authorities within a jurisdiction and home-host coordination across jurisdictions is necessary particularly for the supervision of global systemically important banks supervision. Such joint initiatives could include system-wide scenario analysis and stress tests on climate-related risks. System-wide and cross-border information via supervisory colleges would further aid coordinated supervisory and regulatory policy actions in the region.

Conclusion

Across Asia, the landscape on prudential regulation is quite fragmented despite the systemic nature of climate which require collective action. Setting goals, exposure assessments, data collection and longer time horizons for calibrating capital requirements are among the many actions regulators and banks can take to increase their capacity in managing climate-related financial risks. In addition, there are many existing guidance and frameworks to assist these processes. On top of these actions from individual countries, it is possible to tame the green swan and avoid unintended consequences by employing coordinated, system-wide efforts.

This page was last updated July 4, 2024

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