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Greenland : amazing iceberg on the sea, we can still see this before complete climate change

Climate change creates risks to both the safety and soundness of individual firms and to the stability of the whole financial system. These are already starting to crystallise and have the potential to increase substantially in the future.The challenge for firms is considerable, and perhaps not unlike that posed by market risk and capital adequacy requirements in the 1990s. Then, as now, there was a pressing need for risk managers and boards to accelerate capacity to assess and manage risks and, at that time, most rose to the task.Climate change is the most pressing challenge to the financial system of modern times. The Bank of England – currently consulting on the topic – has done a fine job of pushing it up the agenda for the financial system, although the process of change remains at an early stage.To facilitate this,&nbsp;<a href="https://razor-risk.com/" target="_blank" rel="noopener" data-mce-href="https://razor-risk.com/">Razor Risk</a>&nbsp;in partnership with its clients, is creating a climate risk management service by undertaking stress tests and scenario analysis used to explore less well-understood risks that are not neatly linked to the financial cycle – such as climate changeOur objective is to test the resilience of the current business models of firms to the physical and transition risks posed by climate change. We plan to focus on sizing risks, rather than testing firms’ capital adequacy or setting capital requirements, allowing each firm to examine and potentially adjust its business models.Climate “risk appetite”We are collaboratively working with clients to inform their climate change “risk appetite” with a model designed by our engineering and consulting team. Initially, the model will be implemented as a “proof of concept” for testing, accuracy and efficacy given the various scenarios that need to be measured for risk purposes.This is new territory. Our approach differs from traditional stress tests in several areas:<ul><li>Expert Knowledge: The central concept is to both elicit experts’ individual views regarding climate change via an interactive questionnaire and use machine learning to gain an understanding of sentiment of published scientific papers on climate change.</li></ul>Retrieving expert views in such a fashion generates many pathways of understanding. Even if opinions do not converge, a Bayesian Belief Network will compile all views and produce a unifying Bayesian graph, effectively giving a mathematically correct summary of expert opinions. Most importantly, this graph is not merely a qualitative illustration but provides. a fully computable model of the climate change domain, making it easier to simulate consistent what-if scenarios.Named after its inventor, the 18th-century Presbyterian minister Thomas Bayes, Bayes’ theorem is a method for calculating the validity of beliefs (hypotheses, claims, propositions) based on the best available evidence (observations, data, information). A simplifying, non mathematical, description could be thought of as: Initial scenario plus new evidence equates to a new and improved scenario.The theorem was one of the mathematical tools used to crack to infamous Nazi Enigma code in World War II. Alan Turing, a British mathematician, used Bayes Theorem to assess the translations culled from the Enigma encryption machine used to crack the German messaging code. Applying probability models, Turing and his staff were able to break down the almost infinite number of possible translations based on the messages that were most likely to be translatable, and ultimately crack the German Enigma code.<ul><li>Multiple scenarios: We will test the resilience of our partner firms against three climate pathways. These will include scenarios that embody the risks of ‘earlier’ and ‘later’ policy action to reach the Paris Agreement target, and a ‘no additional policy action’ scenario where the Paris Agreement target is not met, and more severe physical risks crystallise as a result.</li><li>Extended modelling horizon: we will use a 30-year modelling horizon. This is because climate change, and the policies to mitigate it, will occur over a much longer timeframe than the normal horizon for stress testing. To make these scenarios credible and tractable, we propose to examine firms resilience using a fixed balance sheet, focusing on sizing the risks and the scale of business model adjustment required to respond to these risks, rather than testing the adequacy of firms’ capital to absorb those risks.</li><li>Integrated climate and macro financial variables: we will also provide pathways for temperature, emissions, and climate policies to capture the underlying physical and transition risks in each scenario.</li><li>Counterparty-level modelling expectations:&nbsp;We will assess the vulnerability of individual counterparties’ business models to the underlying climate-related risks in each scenario.</li></ul>There are many challenges involved in such an exercise and this approach seeks to balance various trade-offs. The fact that we can generate scenarios from a Bayesian graph model the same way as a statistical model estimated from “Big Data” is both innovative and yet well proven.Although this is a new approach, we believe it is the only one viable to help firms stress-test their potential risks on climate change, because the data doesn’t exist to use a more familiar, data-based model. Fortunately, formally-encoded collective expert knowledge is now available to us and, we believe, both represents what is currently known and aligns to the challenges posed by climate change.Richard Bennett, CEO Razor Risk 19th February 2020

How should firms stress test for climate change?

Through the bi-annual Financial Stability Review issued in November, the European Central Bank (ECB) warned of potential side effects of its loose monetary policy, highlighting how years of unprecedented stimuli designed to bolster the economy is contributing to an erosion of financial stability.The Review goes to the heart of the challenge faced by the ECB, which has only just decided to increase stimuli amid a weakening euro-area economy. The Governing Council cut rates deeper below zero in September and announced fresh asset purchases. The ECB cautioned that its new round of quantitative easing, set to continue until inflation returns to the target of just-below 2%, will further limit the amount of high-quality government bonds available to private equity investors and could in turn lead to collateral shortages in the euro-area repo market, hampering short-term lending between banks.Downside risks to global and euro area economic growth have increased and continue to create financial stability challenges. Low interest rates should support economic activity in the euro area but may also encourage excessive risk-taking by some non-bank financial institutions and highly leveraged non-financial corporations, and in some real estate markets.Non-banks, such as private equity investment funds, insurance companies and pension funds, which play an increasingly important role in the financing of the real economy, have continued to take on more risk and have increased their exposure to riskier segments of the corporate and sovereign sectors. In the event of a sudden repricing of financial assets, growing credit and liquidity risk in some parts of the euro area non-bank financial sector – coupled with higher leverage in investment funds – may lead non-banks to respond in ways that cause stress to spread to the wider financial system.Pockets of vulnerability also remain in the non-financial corporate sector and some property markets. Low funding costs appear to be encouraging more borrowing by riskier firms. At the same time, property markets in a number of euro area countries have continued to see rising prices. As an antidote, the European Central Bank is encouraging authorities in euro-area member states to make more active use of macro-prudential tools, such as encouraging banks to build up capital buffers to mitigate some of the risks.Euro area banks’ profitability prospects have deteriorated further, despite expectations of a modest but continued increase in net interest, fee and commission income. Return on equity of euro area banks is expected to face further pressure from both a weaker economic outlook and persistent cost inefficiencies and overcapacity. Even so, the banking sectors’ solvency position remains robust with a Common Equity Tier 1 ratio of over 14%. And even under an adverse stress scenario, the aggregate solvency ratio is expected to remain above 11%.Climate change, a topic of increased interest to governments and central banks recently, received some brief attention. “Progress has been made in understanding how the financial system may be vulnerable to the physical risk of climate change and to risks from a slow response to the need for a transition to an economy with lower carbon emissions,” the ECB spokesperson said. But policy makers still face significant gaps in available data, risk management and stress-testing frameworksRichard Bennett, CEO 2nd December 2019

Challenges to Financial Stability in the Eurozone

It’s often said that in every crisis there is an opportunity. And in the case of the financial crisis, the regulators, mandated by the G20, seized the moment. The crisis prompted a comprehensive overhaul of banking regulation. This was not just at a UK or European level but, through the G20and the Basel Committee on Banking Supervision, these reforms became a global project.The primary aim was to address specific issues that had been laid bare by the crisis. This was the first step. But regulators knew, of course, that the latest crisis is never a blueprint for the next one. The next crisis might come in a completely different form. So the second step was to enhance the general resilience of banks, to make them strong enough to withstand any type of storm. This idea underpins the three main building blocks of the reforms: capital, liquidity and governance.Much has been done on these three fronts. Regulations have been put in place that mean banks not only have to hold more capital than they did before the crisis; but their capital also needs to be of higher quality. Banks can therefore suffer more losses before they actually fail. At the same time, banks have to fulfil much stricter liquidity standards than before, providing them with a cushion in case trust evaporates and funding dries up. This allows banks to survive in a crisis for longer than they could in the past.Reforms to improve governance and risk management have also come about, but these have received less attention. For too long, governance and risk management have taken a backseat in public or academic debates. But they are just as important as capital and liquidity – if not more important. After all, good governance and sound risk management help to prevent a bank from getting into trouble in the first place. Capital and liquidity are merely backstops for bad management – or bad luck.The new rules help and encourage banks to set up appropriate processes and integrate them into their organisational structures. In this context, one of the standards developed by the Basel Committee is somewhat underappreciated. Specifically, the BCBS 239 Principles for Effective Risk Data Aggregation and Risk Reporting plays a significant role in adequately managing the risks of a bank. In order to make sound decisions, top management needs sound data.The BCBS 239 Principles set out a standard for the larger, more complex financial institutions to work towards and in recent times larger domestic banks and other financial institutions such as larger brokers are also being asked to invest in this governance standard. Banks have made significant investments in the data capabilities needed to meet rising regulatory demands—yet they are still struggling to keep pace. According to banks’ own quantified self-assessments, overall compliance levels have actually declined since 2015.At the top of the list of governance-related challenges are the increasing scrutiny that banks expect in the near future and the rising levels of investment needed in data and technology capabilities. These challenges can be met, however, if banks are able to create value from data as they tackle the governance agenda. In other words, the data vision and strategy that banks deploy to meet governance needs and contribute to overall safety and soundness also support business goals. While banks remain primarily focused on risk data compliance, a few have begun to also use the data strategically to support business growth through advanced analytics and digitisation.The goals of governance and business value can be pursued simultaneously. Compliance efforts are leading to enterprise-wide data-quality controls and governance established on the same data has also been used that to yield business value. Through machine learning and other advanced analytics methods, high-quality, well-governed data will provide the basis for the insights which are needed to realise business value in a range of situations.Supervisors have been meeting with banks’ boards of directors and senior management to obtain an update of the banks’ progress in their implementation of the BCBS 239 Principles and BCBS plans to conduct the next implementation monitoring exercises this year. In light of the current national and geopolitical stresses combined with an economic slowdown influencing the world markets, it will be interesting to see what progress they will report.

Banking reforms and governance in an increasingly anxious world

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How should firms stress test for climate change?

Challenges to Financial Stability in the Eurozone

Banking reforms and governance in an increasingly anxious...