While 2021 has seen a sharp and increasing global focus on climate change, the wider topic of sustainability and the integration of sustainability-related risks is also high on the regulatory agenda for banks and insurers. Environmental, Social and Governance (ESG) considerations are both all-encompassing and a permanent part of financial services activities, transformation, and risk management.
Key sustainability risks relate to the structural change risks that are necessary to ensure a move from a carbon-intensive environment to zero net emissions one, known as ‘transition risk', and risks associated with changing weather patterns, known as ‘physical risks'.
To supplement the regulatory agenda on climate change, the Bank of England's (“BoE”) Biennial Exploratory Scenario (“BES”) exercise in 2021 aims to explore the resilience of the largest UK banks and insurers to the physical and transition risks associated with climate change, as part of a Climate BES (“CBES”).
The CBES will be a learning exercise in nature, in order to size financial exposures of UK institutions to climate-related risks, understand the challenges from these risks to business models, and to help enhance the management of these climate-related risks. It is worth noting that results from the exercise may duly inform the future approach to system-wide policy issues, and the Prudential Regulation Authority's (“PRA”) future supervisory approach, however they will not be used by the BoE to set capital requirements.
Regulators, international bodies and other policy-makers have continued to launch, publish and prepare a raft of guidance, requirements and expectations for financial services providers. The UK's BoE is often seen as an early adopter or driver of new policy. As such the latest publications are a reasonable expectation of what policy makers are thinking and may follow in other jurisdictions, such as the EU.
The CBES will examine participants' vulnerabilities to the two key risk areas under three separate scenarios, termed “Early Action”, “Late Action” and “No Additional Action”, linking into varying degrees of speed at which the climate policy will intensify, and will in particular hone in on the adaptability of business models in light of climate change, over the period 2021-2050. The thirty-year horizon is notably longer than a typical stress test, however this is designed to ensure the CBES captures climate change financial risks crystallising over a much longer timeframe than the typical horizon for stress testing.
Participants will be asked to complete a suite of quantitative data templates in addition to a free-text qualitative questionnaire. A static balance sheet principle will be employed for the majority of quantitative projections, which will remove the complexity of forecasting balance sheet changes over a multi-decade horizon. Multiple reporting points are required to test the financial system's sensitivity to varying levels of stress over a scenario, with a requirement to report projections every five years, i.e. year 0 for actual exposures followed by years 5, 10, 15, 20, 25 and 30.
Before the final results are published in May 2022, the BoE expects to run a second round of the exercise, launching at the end of January 2022 which could focus on exploring potential interactions between participants' first round responses.
What will be expected of banks and insurers?
For banks, the CBES focuses on the credit risk associated with the banking book, with an emphasis on high-quality analysis of risks to large corporate counterparties. A key metric will be the cumulative total of provisions against credit-impaired loans at various points in the scenarios. Analysis is expected to extend to at least the 100 largest and most material corporate counterparties (where those exposures are greater than £10 million) however, it is strongly encouraged to extend the detailed analysis to more corporate counterparties than the top 100, consistent with expectations set out in Supervisory Statement 3/19 and the Dear CEO letter dated 1 July 2020 which should be embedded by end-2021.
For insurers, the CBES will focus on changes in Invested and Insurance, assuming an instantaneous shock, meaning that the stress brings forward the future climatic environment to today's balance sheet.
It is expected that internal governance processes around CBES submissions should involve effective challenge from senior management, inclusive of relevant committees and the board of directors, with qualitative questionnaire responses recommended to include details of such governance and quality assurance and a summary of the key issues that were challenged by senior management or relevant committees, and what changes to responses were made following this challenge.
Submissions should also contain a statement as to how institutions have satisfied themselves that the data templates and the responses to the qualitative questionnaire have been completed as accurately as possible and that the appropriate level of quality assurance has been applied.
A key consideration will be that institutions consider the management actions they would take in response to the scenarios, formulating their management actions as if they were observing the scenarios unfold in real time rather than assume with perfect foresight.
Why Grant Thornton?
Grant Thornton's Financial Services Risk, Consulting and Advisory teams are comprised of dedicated experts who are experienced in supporting banks and investment firms with a variety of regulatory and ESG challenges.
In particular, our industry-leading Prudential Risk team understands that regulation continues to drive the strategic agenda for banks and investment firms. ESG and other sustainability related areas are likely to be high on the regulatory agenda for years to come. They specialise in assisting clients across the financial services sector in navigating through the maze of regulation and support clients to identify regulatory obligations and work towards full compliance balanced with your business needs.
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