Climate Risk – A 4most Update

As the memory of a summer filled with heatwaves and record-breaking temperatures subsides, it is clear that the need for the financial services industry to focus on climate initiatives is not going away, and nor should it. In 2021 there was a large amount of activity as organisations prepared for and submitted their responses to the CBES exercise. This has been followed up in 2022 by the release of the results of the exercise and smaller organisations, i.e., those not participating in the CBES, developing their own approaches.

4most has continued to enhance its approaches and understandings across the spectrum of climate-based challenges and this has been achieved with clients, in conjunction with the Government’s Innovate UK and through our own R&D investment. We have observed that industry level credit stress models for banks over a 30-to-50-year horizon appear to be severe but not systemically unmanageable or necessarily requiring significant increased capital allocation. This comes as somewhat of a dissonance to the very material shifts that we will witness in terms of our daily lives, be that through changes to food production, water supply, transitions to renewable energy or many other transmission channels.

If this is correct, it must imply that the cost of climate change is being borne by some other part of the economy. It remains to be seen where that will lie or if further stress is needed to fully reflect the true impact on the industry. In any event for individual banks, it will become increasingly important to have a detailed understanding of where the climate related credit stresses are concentrated to provide support to the outcomes and, where necessary, manage these balance sheet exposures or price appropriately to avoid adverse selection in the market.

One of the key internal focus areas is how we enhance our climate stress testing methodologies in light of new understanding, revised regulatory guidance and benchmark results – such as that of the CBES. These methodologies take both physical and transition risks within portfolios and translate into forecasts of ECL & RWA impacts over an extended time i.e.. 50 years. The approaches generally look to use bottom-up simulation methods and transition accounts to varying states after which the ECL and/or RWA can be quantified, aligned to an organisation’s existing internal models.

Due to its relative immaturity across the industry, this is a continually evolving area and one which requires constant enhancements and review; not least for ourselves due to the need to maintain our stress testing as a service solution and ensure it remains as industry best practice.

Some of the recent changes have been to improve how the engine simulates a reduction to land value for extreme cases and applying functionality such that certain transition risks can be treated as a cost to improve the property rather than an assumed reduction in property value. This is alongside the ongoing alignment of key parameters based on updated data and also, where appropriate, to provide enhanced alignment to external benchmarks such as the CBES results.

Additionally, to address our subscribers needs, we are also enhancing the functionality to provide forecasts on both static and dynamic balance sheet movements. This is something that we have developed for bespoke projects but had not yet integrated into our standard service offering, due to the variations in forward financial planning approaches across organisations. Whilst not generally required for regulatory driven requirements, we feel that this is a key tool for strategic planning. That is because it allows firms to understand the levers available to them and the speed at which the portfolio shifts will occur and how this aligns to the emergence of the risks and impacts.

In addition to our work on stress testing solutions, we are also in the process of developing a Green Transition Preparedness Score. This development will allow businesses to be scored on the level of change required and their preparedness for Climate Change for use in decision making and monitoring of banking portfolio compositions. This work has been undertaken as part of Innovate UK’s Small Business Research Initiative for which we have partnered with Swish Fund. We have also been supporting clients with the reporting of scope emissions within banking books, manipulating internal data to meet accountancy standards and climate risk on the automotive industry.

The speed at which lenders are responding to these challenges varies greatly across the industry, with some beginning to embed climate fully and others only just beginning to develop real capabilities. However, it is clear that there is still a long way to go to something that resembles a long-term industry wide approach or framework, and we will continue to challenge our own thinking and practices to provide the most up to date solutions.

To learn more contact us at info@4-most.co.uk