Climate stress, Libor triggers and life beyond silos

Show don’t tell: BoE’s climate stress test dilemma

Making the test easier to run could come at the expense of building risk management capacity

LCH targets hardwired pre-cessation triggers

Proposal aims to align transfer pricing for cleared and bilateral markets in the event of split on ‘zombie Libor’ triggers

Bank disruptors: JP Morgan smashes silos

To foster innovation, the US banking giant rebuilds its culture by breaking boundaries

COMMENTARY: Decomposing climate risk

This year, UK banks and insurers must prepare regulatory stress tests with an unprecedented scope, as the UK Prudential Regulatory Authority’s stress tests in 2021 include climate risk for the first time – but this should be only the first step towards incorporating the hazard into bank risk management practice.

Open for comments until March, the stress test proposal includes testing a static portfolio for the next 30 years at five-year intervals against three climate scenarios, which can broadly be described – in descending order of preference – as “tough but survivable”, “very bad but just about survivable” and (the worst) “current policy goals”. The last scenario will include the anticipated harm if current emissions policies continue, with the damage expected to occur between 2050 and 2080 (but brought forward to 2050 to ensure its inclusion in the 30-year window).

It’s an important step forward, and will, with any luck, help focus the minds of regulators and banks elsewhere. Late last year, European institutions were digging in their heels against the idea of incorporating climate risk into prudential capital rules. Some argued that without a loss history the risk could not be reliably modelled; others warned that capital requirements should not be used to promote other policies, but should solely reflect the risk involved in the business.

These complaints miss the point.

It’s perfectly true that there is no historical record of credit or insurer losses during periods of climate change, and that modelling such a scenario involves uncertainties over and above those that normally surround risk modelling. But the alternative – not trying to include climate change in a risk scenario – assumes its consequences will be zero. Compared with that sort of head-in-the-sand approach, almost any attempt at including climate risk is an improvement.

It could be argued that capital rules shouldn’t be used to achieve unrelated policy goals (for example, encouraging pro-union policies by forcing lower risk ratings on the debt of unionised companies, however laudable as a goal, would distort credit markets and potentially produce an asset bubble). But climate risk, whether vulnerability to flooding or exposure to the debt of fossil fuel producers, is not an unrelated topic. The risk will affect the bottom line of institutions, and sooner than many think.

The Bank of England’s climate stress test is a good first step, but no more than that – the end goal must be the disappearance of climate risk as a separate heading. The future of the financial sector will include losses caused by climate change. Catastrophe risk modelling needs to include climate risk. Credit modelling needs to include vulnerabilities to stranded fossil-fuel assets and emission-control laws. Operational climate risk isn’t a debatable add-on to other models, it is part of the future of risk. These factors need to be integrated as quickly as possible into risk modelling, not only in the UK but around the world.

STAT OF THE WEEK

Less than half of the lenders evaluated as part of the European Central Bank’s 2019 annual Supervisory Review and Evaluation Process (SREP) scored highly. SREP scores banks on their risk management, governance, business model and other factors from one to four, with four being the worst. Of the banks assessed in 2019, 49% had a score of two, down from 52% in 2018 and 2017. No banks have achieved a score of one over the last three years.

QUOTE OF THE WEEK

“We had a great opportunity to align all those products and geographies but things haven’t really worked out that way. That’s unfortunate and makes the world a little more complex” – Tamsin Rolls, JP Morgan, on the fractured landscape of new risk-free rates (RFRs). The US selected a secured benchmark but the UK and eurozone went with unsecured rates. Meanwhile, bond and derivatives markets have begun moving to compounded-in-arrears versions of new RFRs, as forward-looking term rates and credit-sensitive benchmarks are developed for the loan market.