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Climate risk: Bank of England finds gaps in UK financial system

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The Bank of England (BoE) has published its latest thinking on climate-related risks and regulatory capital frameworks.

  • The BoE has released a report on climate risk in the UK financial system following work carried out internally and with a wide range of stakeholders.
  • It included updates on capability and regime gaps, capitalisation timelines and areas for future research and analysis.
  • Moving forward, the central bank will ensure that firms continue to make progress to address capability gaps and support initiatives to enhance climate disclosures, among other goals.

In October 2021, the UK’s central bank published its Climate Change Adaptation Report, setting out that the current frameworks already capture climate-related risks to some extent, including through capital models and credit ratings. There is acknowledgement, however, that understanding these risks still has capability gaps, whereby it is difficult to estimate them, and regime gaps, meaning they cannot be captured in the existing capital regimes.

The Bank committed to undertaking further work on these topics, engaging with stakeholders as well as undertaking its own internal assessments. In its latest thinking, it illustrated the key findings, identifying areas for future work.

What firms should do…

According to the BoE, there is uncertainty over whether banks and insurers are sufficiently capitalised for future climate-related losses due to capability and regime gaps. Regulators, including the Bank, need to form judgements on whether quantified and unquantified risks are within risk appetite, and act accordingly.

If all firms regulated by the Prudential Regulation Authority (PRA) – which are around 1,500 banks, building societies, credit unions, insurers and major investment firms – had effective risk-management controls in place, they would have to invest less into their resilience in the future, and vice versa. The Bank said that ensuring firms make progress to address ‘capability gaps’ to improve their identification, measurement, and management of climate risks is one of its short-term priorities.

In terms of ‘regime gaps’, the Bank found that the unique characteristics of climate risks mean that capital frameworks need a more forward-looking approach than used for many other risks. Scenario analysis and stress testing will play a key role in this, with regulators and firms expected to make further progress in this regard.

… and what regulators should do

The BoE said that existing time horizons over which risks are capitalised by banks and insurers are appropriate for climate risks, which warrants keeping the policy on these time horizons as it is.

It noted, however, that further work is needed to assess whether there may be a regime gap in the macroprudential framework. Indeed, any use of macroprudential tools would need to be assessed carefully against how well they mitigate climate risks, their behavioural impacts, and the potential for unintended consequences. 

Calibration of macroprudential tools would also be challenging given uncertainties around climate risks and the need for them to help facilitate an orderly transition to net zero. The Bank said it will explore the nature and materiality of such regime gaps as part of its ongoing policy work and consider whether action to address them would be appropriate.

What next?

Looking ahead, the Bank said it will progress work to meet various goals, including ensuring that firms continue to make progress to address capability gaps and supporting initiatives to enhance climate disclosures.

It will also build its capabilities and forward-looking tools to judge the resilience of the financial system to climate risks, promote high-quality and consistent accounting for climate risks, and build an understanding of and address material regime gaps in the capital frameworks. 

The BoE has been saying that climate risk is a strategic priority for some time, with the PRA already stating in its 2020-21 that it needed to be managed immediately. Authorities are under pressure to act quickly, but accurately measuring the risks depends on data and methodologies that will mature over time.

Other central banks continue to take steps to address climate risk. For example, March 2023 also saw the European Commission asking the EU’s banking, insurance and securities regulators to conduct a stress test of the entire financial system, while The Canadian financial industry regulator, the Office of the Superintendent of Financial Institutions, imposed mandatory climate disclosures.

As climate risk becomes more embedded in financial systems, it will become a priority for all actors across the value chain, as companies and entrepreneurs will need to provide calculations in order to obtain financing, while investors may decide to drop assets if they lack longevity. Acting in collaboration will help avoid market fragmentation and limit vulnerabilities, especially at a global level.

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