Climate-related Risks and the Regulatory Capital Framework

Enduring gaps in the understanding and management of climate risks create uncertainty over whether banks are sufficiently capitalised against them, according to this Bank of England (BoE) report.

The report sets out the bank’s latest thinking on climate change and capital requirements and commits to addressing persistent difficulties in identifying and measuring climate-related financial risks (CRFRs), referred to as climate “capability gaps”, as an immediate priority. It also states that while climate-related macroprudential reforms may be justified to ensure financial stability, more research is needed to analyse possible “regime gaps”, or the incomplete capture of climate risks under existing capital frameworks, and align policy changes with a smooth and orderly transition to net zero.

Capability gaps create uncertainty over the materiality and distribution of risks. This uncertainty undermines the effective calibration of capital controls, as prudential authorities rely on firms’ abilities to identify, manage and measure foreseeable risks when calibrating the quantum of capital required to provide resilience against unexpected losses.

The BoE commits to supporting firms to develop their capacity, and states that failure to advance disclosure standards or adequately capitalise material risks may result in supervisory action.

The BoE report outlines firms’ responsibilities under Pillar 2 of the Basel framework to address capability gaps and embed CRFRs in their governance and risk management processes.

According to the report, CRFRs should be incorporated in internal capital adequacy processes and firms should disclose relevant contextual information from these assessments. Firms should also enhance their climate-related accounting by improving data, modelling capabilities, governance, and controls, and by taking a strategic approach to transition planning.

To identify and resolve possible regime gaps, the report calls for further research and says that firms and regulators must explore how methodologies can be adapted to better capture CRFRs in capital frameworks. Advancing the use of forward-looking analysis, such as scenario analysis and stress testing, by the BoE and the firms under its supervision is identified as a crucial measure for addressing CRFRs within current policy horizons.

The report recognises that inaction on the transition to net zero may lead to a build-up of systemic risks that warrant the use of specialised macroprudential tools to ensure the financial system’s resilience.

Climate-specific concentration limits and disincentives are flagged as possible tools to address systemic risks “not adequately captured by pillars 1 or 2 of the microprudential capital requirements”. However, the report notes challenges in calibrating these due to uncertainty around climate risks.

The authors of the report call for more research into the possible “unintended consequences” of regime changes, particularly in instances when these may negatively impact an orderly transition or result in stranded assets.