BoE warns against extending bank capital time horizon to account for climate risks

It follows a period of study on the topic building on the Bank’s 2021 climate change adaptation report.

The Bank of England (BoE) does not favour introducing horizons for banks to assess climate risks and set capital buffer levels.

Regulatory capital frameworks in the UK and elsewhere largely calibrate bank capital requirements over a one-year period to ensure financial institutions are resilient to the risks of near-term unexpected losses.

The BoE had previously conceded that, while current capital frameworks captured climate-related risks to some extent, the typical one-year time horizons might be a poor fit for climate-related risks given that they crystallise over longer time horizons compared to other risks.

Longer time horizons are already in use to ensure that banks maintain adequate financial resources in some contexts. Banking stress-testing frameworks, for example, often consider a time horizon of three to five years, designed to cover the duration of losses that firms might face from a typical macroeconomic shock.

In a report released on Monday, however, the BoE said it expects that a one-year period will still be sufficient for banks to recapitalise following a climate-related loss. It also noted the increasing use of forward-looking information to capture climate risks, and initiatives to enhance the quality and availability of such data. These would help banks better recognise expected losses through accounting and market valuations, it said.

There could also be unintended consequences for such “a fundamental change to the regulatory capital frameworks”, it warned.

Extending the regulatory time horizon would lead to earlier recognition of risks in the capital frameworks of banks and insurers, which could remove funding and overage – and increase the so-called “protection gap” – for some sectors.

It could also introduce greater complexity into the prudential framework, which “would need to be justified alongside the coherence of the framework”, the BoE said.

“Current evidence suggests that the existing time horizons over which risks are capitalised by banks and insurers are appropriate for climate risks. Therefore, there does not appear to be sufficient justification for regulators, including the Bank, to make a policy change to these time horizons.”

The Bank said it will continue to explore how climate risks can be calibrated within the timelines embedded in existing capital frameworks. A key priority will be to improve the ability of internal bank systems to identify, measure and manage climate risks.

The bank will also consider the proposed use of dedicated prudential treatments for assets based on their climate exposure. Such a mechanism would allow supervisors to reduce the amount of capital banks are required to set aside for green assets or conversely increase the requirements for polluting assets – known as introducing a green supporting factor or a brown penalising factor, respectively

The BoE’s research on the topic builds on its 2021 Climate Change Adaptation Report, which set out early thinking on climate change and the regulatory capital frameworks for banks and insurers.

ESAs address structured finance

Separately, the European Supervisory Authorities (ESAs) have announced plans to enhance climate change-related disclosure requirements for structured finance products.

The three EU financial regulators said that such transactions are often backed by assets that could be directly exposed to physical or transition climate-related risks, such as real estate mortgages or auto loans.

The lack of readily available data for the assets means it is difficult to assess climate-related risks, and impedes classification against the EU taxonomy and SFDR regime, they concluded.

In addition, the data is key for the European Central Bank, which is one of the largest investors in the asset class through its asset purchase programme.

No timeline was provided by the ESAs for the exercise.