Basel Committee issues principles for the effective management and supervision of climate-related financial risks for banks worldwide

After a consultation in November 2021, the Basel Committee has now issued its final principles for the effective management and supervision of climate-related financial risks which aim “to promote a principles-based approach to improving both banks’ risk management and supervisors’ practices”.

Even though the existing Basel Framework, namely the Core Principles for effective banking supervision (BCPs) and the supervisory review process (SRP), is considered broad and flexible enough to also cover the measures necessary to take into account climate-related financial risks, the Committee is of the opinion that additional guidance would foster the alignment of supervisory expectations.

The publication encompasses 12 principles addressed to banks and 6 principles addressed to prudential supervisors, each referring to the corresponding principles in the BCP and SRP and all intended to be applied in a proportionate manner. The areas covered by the principles include corporate governance, internal controls, risk assessment, management and reporting.

Corporate governance

The bank should clearly assign climate-related responsibilities throughout its organisational structure. Climate-related risks should be taken into consideration in business strategies and the approach communicated to managers and employees. The board and senior management should have an adequate understanding of the risks for these purposes and be equipped with the appropriate skills and experience to manage such risks. The board and senior management should also take a long-term consideration of climate-related financial risks. Overall, banks should adopt appropriate policies, procedures and controls that are implemented across the entire organisation to ensure effective management of climate-related financial risks.

The Committee specifically asks banks to review their compensation policies in order to ensure consistency with the inclusion of material climate-related financial risks in their business and risk strategy, objectives, values and long-term interests. In doing so, empty words not followed by (sufficient) actions are supposed to be prevented. In addition, internal strategies and risk appetite statements should be consistent with publicly communicated climate-related strategies and commitments.

Internal controls

Climate-related financial risks should also be incorporated into the internal control frameworks across all three lines of defence, e.g. the assessments during the client onboarding as well as credit application and review processes, assessments of compliance with rules and regulations and assessments of the quality and effectiveness of the overall internal control framework.

Risk assessment, management and reporting

Generally, banks should identify, quantify and manage (material) climate-related financial risks as part of their risk management, capital and liquidity needs. Where appropriate, material risks should also be incorporated into stress testing programmes. The potential need to monitor the concentration of such risks is referred to several times

Furthermore, banks should understand the impact of climate-related risk drivers on credit risk profiles, market risk positions, liquidity, operational and other risk positions and ensure that the respective risk management systems and processes consider material climate-related financial risks.

To be able to do so, banks should have systems in place to collect and aggregate climate-related financial risk data across the group as part of their overall data governance and IT infrastructure. In this context, banks are required to consider actively engaging clients and counterparties and collecting additional data in order to develop a better understanding of their transition strategies and risk profiles and reporting should be timely and updated regularly.

Scenario analysis

Scenario analysis should be used where appropriate to assess the resilience of the business models and strategies to a range of plausible climate-related pathways and to determine the impact of climate-related risk drivers on the bank’s overall risk profile. The analysis should reflect relevant climate-related financial risks for banks and be proportionate to the bank’s size, business model and complexity.

Regular review

Since sustainability discussions are highly dynamic, climate science as well as data quality advances every day and practices and methodologies are expected to evolve rapidly, particularly regarding scenario analysis, banks should continuously develop their capabilities and expertise and challenge and review their processes.

Next steps and interaction with pre-existing approaches 

The Committee expects the principles to be implemented as soon as possible.

However, in relation to the EU, the principles largely echo and are aligned with approaches already taken by EU authorities such as the ECB’s guide on climate-related and environmental risks (see our blog post on the latest results of the assessment of the guide’s implementation) and the Commission’s proposals for amendments to the Capital Requirements Regulation and the Capital Requirements Directive (see our blog post on the ESG aspects of the Banking Package 2021). It remains open whether there will be any further implementation measures.

In relation to the UK, the principles are broadly also in line with the supervisory approach set out by the Bank of England in its Climate Change Adaption Report 2021 when combined with the TCFD disclosure obligations.