Fundamental climate-related and environmental (C&E) risk considerations in the ICAAP

The Basel framework is composed of three pillars. While Pillar 1 establishes minimum capital requirements in accordance with the regulatory view, and the purpose of Pillar 2 is to address risk governance, internal controls and risk management to form a well-developed internal view on capital, Pillar 3 is meant to ensure transparency by requesting supervisory reporting and public disclosure. The ICAAP is part of Pillar 2, also serving as an important input to the Supervisory Review and Evaluation Process (SREP).

The starting point of the ICAAP requirements is Article 73 of the Capital Requirements Directive (CRD IV), which has been transposed differently in each EU Member State, resulting in a wide variety of ICAAP practices. This article focuses on the requirements applicable under the supervision of the European Central Bank (ECB).

The ECB’s view on the ICAAP is elaborated in the “ECB Guide to the internal capital adequacy assessment process (ICAAP¹)”, but there are also other international documents (in addition to the relevant European Union and national legislation) which are to be considered, including various publications of the European Banking Authority (EBA²), the Committee of European Banking Supervisors (CEBS), the Basel Committee on Banking Supervision (BCBS) and the Financial Stability Board (FSB).

The ICAAP Guide’s seven principles serve as the basis of assessing each bank’s ICAAP as part of the SREP and in the corresponding supervisory dialogue.

Maintaining adequate capitalisation of banks requires the forward-looking identification and effective management of all material risks (using an appropriate combination of quantification and controls) and covering them with a sufficient amount of high-quality capital.

The ICAAP is a well-established process in most banks, but C&E risk aspects present additional challenges in this respect. In this article, we discuss the main implications of C&E risks for the ICAAP.

Banks have to describe in their Risk Appetite Statements (RAS) their view on the risks they are or may be exposed to and define their intended actions to address them in line with their business strategies. The ICAAP process and its outcome can facilitate sound and effective risk management, providing useful inputs for setting up an adequate risk monitoring and reporting system and a reasonably granular limit structure.

The ICAAP framework and process are meant to regularly reassess the bank’s risk appetite, with due consideration to its risk profile and key vulnerabilities, including material C&E risks. Integration of any risks into the RAS requires the design and calibration of relevant decision-useful risk metrics (Key Performance Indicators – KPIs, Key Risk Indicators – KRIs) which in the C&E risk context can include for example sector- and geography-related metrics, indicators relating to the alignment of exposures to transition scenarios, metrics relevant for EU Taxonomy alignment or portfolio vulnerability to particular physical hazards. In addition to defining the metrics, corresponding thresholds and limits also have to be set as part of the RAS, together with describing the early warning indicators, escalation procedures and management actions.

The key challenge in this regard is the scarcity of relevant and granular data, but the preliminary implementation and analyses can already serve as facilitators of improving the data collection and measurement methodologies which are the pre-requisites of making tangible progress in C&E risk management.

The ICAAP’s objective is to contribute to the banks’ continuity from a capital perspective by ensuring that even during a prolonged period of adverse developments they have sufficient capital to bear their risks, absorb losses and follow a sustainable strategy. Two perspectives need to be applied which are to mutually inform each other and be integrated into all material business activities and decisions.

• Normative perspective: A multi-year assessment of the bank’s ability to permanently fulfil its capital-related regulatory requirements and to cope with other external financial constraints under adverse conditions over the medium term.
• Economic perspective: Identification and quantification of all material risks as instantaneous shocks that may cause economic losses to the bank, in order to adequately cover them by internal capital which supports the bank’s strategy on an ongoing basis.

Both perspectives should mutually inform each other and cover all material risks. As the ICAAP’s scope is not limited to Pillar 1 risks, irrespective of whether the bank considers C&E risks as a separate risk category or interprets them as risk drivers of traditional prudential risk categories, any material C&E risks need to be integrated.

Banks have to implement risk quantification methodologies that are robust, sufficiently stable, risk-sensitive and adequate for their individual circumstances (i.e. they are in line with their risk appetite, market expectations, business model, risk profile, size and complexity). They also need to apply a high level of conservatism to ensure appropriate consideration of tail events and any uncertainties arising from risk quantification methodologies and from the determination of projections. Key parameters in this respect are confidence levels, correlation and scenario assumptions.

Each bank has to establish, calibrate and maintain its risk quantification methodologies in alignment with its own risk appetite, and the stress scenarios also need to be tailored to the bank’s individual circumstances, risk profile, strategy and risk tolerance level. Vendor models are no exceptions either: understanding and adequately customising them remain the responsibility of the bank.

Instead of starting from scratch, banks may opt for complementing their existing rating models with climate scenarios and stochastic simulations. They can also adapt the parametrisation of their portfolio models to account for systematic economic effects through increased correlations and/or adjusted volatility parameters based on climate scenarios or representative stress events such as the current energy crisis. It is not necessary to start with very advanced models such as Climate Value-At-Risk, but the applied methodologies will likely mature in the future.

The ECB’s ICAAP Guide stresses that “risks are not expected to be excluded from the assessment because they are difficult to quantify or the relevant data are not available”, instead tailored approaches and expert judgements (together with appropriate proxies and estimations) need to be applied to compensate for the lack of data and/or sufficiently established methodologies. The risks which are difficult to quantify, such as various C&E risks, also have to be factored appropriately into all relevant risk management and control processes.

Banks should regularly (at least annually) assess their vulnerabilities in order to capture all material risks depending on their individual business models, profiles and operating environment, and define/refine their adequate stress testing programmes accordingly. Under the normative perspective the stress tests take the form of multi-year scenario projections and are preferably informed by the bank’s other stress tests performed throughout the year based on either historical or hypothetical stress events, and also include reverse stress tests. The adverse ICAAP scenarios should be plausible and focused on the bank’s key vulnerabilities.

New threats and significant changes in the external world need to be continuously monitored and identified in order to assess whether the stress scenarios are still appropriate or they have to be adapted to the new circumstances. If there is any material change, the potential impact on the bank’s capital adequacy needs to be assessed “immediately” over the course of the year, instead of waiting until the yearly ICAAP process.

In the context of C&E risks, banks certainly need to improve their forward-looking and pro-active risk identification in order to facilitate effective risk management. The “ECB report on bank’s ICAAP practices” explicitly states that “Starting with risk identification processes, many banks also need to overcome their current silo approaches and start identifying and managing concentrations, particularly across risks. The way things stand, those banks might unconsciously expose themselves to identical or correlated risk drivers that may simultaneously impact them via different risk types, thereby threatening their continuity to a far greater extent than they are aware.”.

Indeed, each C&E risk driver can impact various traditional prudential risk categories at the same time through diverse micro and macro transmission channels.

Although most C&E risk impacts will only materialise in the medium to long term (i.e. beyond banks’ conventional planning horizon), they may have important consequences on for example future cash-flows and portfolio compositions which need to be accounted for under both perspectives, although differently.

• The normative perspective has to be based on a robust and up-to-date capital plan that comprises a credible baseline and adequate, bank-specific adverse scenarios. It needs to cover a forward-looking horizon of at least three years in line with the bank’s business and capital planning, consistently with the estimates of changes in the portfolio composition and risk structure. However, longer-term developments (represented by dashed line below in Figure 4) should also be considered if they have material impact.
• The economic perspective accounts for economic value considerations, assessing them as part of the bank’s stress testing framework and its monitoring and management of economic capital adequacy. It is based on a point-in-time risk quantification whereby long-term effects are taken as instantaneous shocks, therefore any considered risks and losses (irrespective of the time horizon of their materialisation) affect the internal capital immediately and to their full extent.

The adverse projections of the normative perspective have to simulate bank-specific vulnerabilities, and if such projections show a material impact stemming from for example C&E risks, they need to be adequately quantified in the point-in-time calculation and/or complementary stress tests under the economic perspective too.

The internal stress tests can take various forms and can cover different time horizons as presented below in Figure 4. In some cases the impacts of one-off events are simulated in analogy with the 1-year physical (flood and drought) risk scenarios of the 2022 ECB Climate Stress Test. In other cases long-term projections are applied or the long time horizon is contracted to account for a long-term impact on a medium time horizon such as the frontloaded 3-year disorderly transition risk scenario of the 2022 ECB Climate Stress Test. Long-term C&E risk impacts usually cannot be adequately quantified without applying plausible dynamic balance sheet assumptions.