On December 8, 2022, the Basel Committee on Banking Supervision (“BCBS”) released guidance to clarify how climate-related financial risks may be captured in existing capital and liquidity requirements for banking organizations (“Climate FAQs”).1 The Climate FAQs are noteworthy because they indicate that standard setters believe climate-related financial risks should be included in bank capital requirements and begin to define specific obligations for banking organizations.
In this Legal Update, we provide background on BCBS and climate risk regulation and discuss some of the main points from the Climate FAQs.
BCBS has promulgated and revised standards for capital and liquidity requirements for banking organizations for many years, with the most recent major revisions occurring in 2017.2 BCBS also has addressed aspects of climate-related financial risk, most notably by issuing principles for the effective management and supervision of climate-related financial risks earlier this year.3 However, to date there has been little effort to integrate climate risk considerations into the prudential requirements for capital and liquidity, with US Treasury Secretary Janet Yellen stating earlier this year that it is too early to consider adjusting capital requirements for US banks based on climate change-related risks.4
The Climate FAQs are styled as 19 questions and answers on the application of existing capital and liquidity requirements to climate-related financial risks. BCBS states that the Climate FAQs are intended to clarify the application of existing requirements to the unique features of climate-related financial risks and should not be interpreted as changes to the underlying standards. However, several parts of the Climate FAQs define compulsory and prescriptive courses of action for banking organizations and, therefore, arguably do create new obligations.
For example, the response in FAQ #1 states that banking organizations “should integrate climate-related financial risks either in their own credit risk assessment or when performing due diligence on external ratings.” It is hard to see how that is anything short of a new regulatory requirement to the credit underwriting/due diligence process.
Similarly, the response in FAQ #4 states: “When determining whether a given corporate meets the investment grade definition, banks should consider and evaluate how material climate-related financial risks might impact the capacity of the corporate to meet its financial commitments in a timely manner even under adverse changes in the economic cycle and business conditions.” In some jurisdictions, such as the United States, the investment grade determination is a multi-factor analysis that is designed by each banking organization within broad guidelines set forth by regulators. Based on the firm position taken by BCBS in this FAQ, some banking organizations might consider incorporating a climate-related financial risk element in their investment grade determination procedures.
The Climate FAQs also are addressed to national regulators and suggest specific changes to capital requirements to account for climate-related financial risks. For example, the responses to FAQ #6 and FAQ #7 state that national regulators should consider increasing risk-based capital requirements and expanding appraisal requirements for real estate exposures to account for climate-related financial risks.
With respect to liquidity regulation, the response to FAQ #18 indicates that banking organizations should incorporate material climate-related financial risks in their non-standardized liquidity stress testing activities. There are similar extensions of the existing requirements for operational risk and market risk capital requirements in other FAQs.
The Climate FAQs indicate that BCBS has turned a new corner with respect to the regulation and mitigation of climate-related financial risks. Where previous issuances had focused on risk management practices, the Climate FAQs focus squarely on capital and liquidity requirements.
Fierce Debate Likely to Follow
This new focus is likely to engender debate in BCBS member jurisdictions, many of which are contending with the difficult implementation of the Basel Endgame standards for regulatory capital requirements. We expect particularly fierce debate in the United States, where even the risk management and traditional capital proposals from BCBS have been strongly questioned in recent months. To date, US banking regulators have said that they are not currently considering capital and liquidity requirements for climate risks.5 However, given the prominent role U.S. banking agencies have in the governance of BCBS, the Climate FAQs suggest increasing comfort by US regulators in examining how capital and liquidity requirements could be modified to incorporate climate risks. We therefore expect the Climate FAQs to be raised and discussed at congressional oversight hearings next year.
Useful Starting Point, in the Meantime
From a practical perspective, the Climate FAQs do provide potentially useful guidance on how to apply the existing capital and liquidity requirements to climate-related financial risks. To the extent a banking organization is considering how to enhance its risk management practices to better incorporate environmental risks, examining the Climate FAQs is a useful place to start.
1 BCBS, Basel Committee clarifies how climate-related financial risks may be captured in the existing Basel Framework (Dec. 8, 2022), https://www.bis.org/press/p221208.htm.
3 Please see our Legal Update on the BCBS principles.
4 See Christopher Condon, Janet Yellen Says Higher Bank Capital Rules for Climate Risk Are “Premature,” Bloomberg (Feb. 2, 2022), https://www.bloomberg.com/news/articles/2022-02-02/yellen-says-higher-bank-capital-rules-for-climate-premature.
5 See e.g., Testimony by Michael Barr (Nov. 15, 2022) (“The pilot climate scenario analysis exercise … will be exploratory in nature and not have capital consequences.”); Federal Reserve, Climate Change and the Role of Regulatory Capital: A Stylized Framework for Policy Assessment (Oct. 2022) (“Actual implementation entails additional challenges from several perspectives.”).