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Banks Board put on the hot seat on managing climate change risks

Last week, in my article in the Business Daily I predicted the introduction of climate-related requirements or supervisory expectations by regulators such as CBK, CMA, and RBA that will be forcing financial institutions and other private sector companies to strengthen their climate risks and opportunity management. Less than 24 hours later, the CBK issued 18 pages guidelines on Climate-Related-Risk-Management for Banks.

CBK is advising that climate-related financial risks have the potential to significantly increase the banking sector’s credit risk as a result of severe floods, drought, landslides, and wildfires that destroy borrowers’ assets or impair supply chains. Extreme weather events will increase operational risks for banks due to disrupted business continuity from the negatively impacted banks’ infrastructure, systems, processes, and staff. Similarly, with a high reliance on physical collateral in lending in Kenya, climate change effects can increase credit risk as a result of the collateral assets becoming stranded.

The CBK guidelines come at a time when the commercial imperatives for embracing climate risk and opportunities are increasing. In the future, banks will be judged on their green credentials and it, therefore, makes sense for banks to develop green loans offerings as well as assess the climate risks in their existing portfolio. Banks will need to have mechanisms on how to incorporate climate factors into their capital allocations, loan approvals, portfolio monitoring, and reporting processes.

The guideline is sending the financial institutions to the drawing board where they will need to focus on building enablers for climate change risk and opportunity management. There is no doubt that banks do not have the required technical skills, methodologies, and tools to manage climate risks as well as identify the opportunities presented by climate change. Banks will need to urgently acquire/build skills, define the methodologies and develop tools if they are to meet the requirements of the guidelines.

In the recent past, I have been working with a couple of banks that are definitely gaining the first-mover advantage by already making significant strategic decisions in climate risks management as well as unlocking the opportunities provided by climate change such as green lending mechanisms. This has resulted in ramping up climate/sustainable finance, development of new offerings for green lending, and mobilizing new capital for environmental initiatives.

Banks are required to embed the consideration of financial risks from climate change into their governance arrangements, incorporate the financial risks from climate change into their existing financial risk management practice, and develop an approach to disclose the financial risks from climate change.

The guidelines have put the responsibility of climate change management into the hands of the boards of directors who are now required to oversee the effective management of climate-related risks of their banks. This will need a reassessment of the banks’ overall banks strategy, banks objectives, and risk management frameworks. Banks are also expected to come up with disclosure mechanisms on the financial risks as a result of climate change.

The boards and management of banks are required to assess and quantify banks’ exposure to climate-related risks arising from various lines of business and to oversee the development of a climate risk strategy by 30 June 2022.

The new guidelines are also imposing various requirements that will force banks to ramp up their capabilities, including the collection of data about physical and transition risks, modeling methodologies, risk sizing, understanding challenges to business models as a result of climate change, and improvements to risk management.

Considering that climate risk management is now officially a function of the board, there is a need for banks to come up with robust climate-risk governance within the organization that should be cascaded throughout the organization. Designing of such a governance structure will be key to ensuring the flow of information and responsibility for actions. From my own assessment, the current governance structures and related policies are not robust enough to address the requirements of the guidelines and hence calling the banks to formulate a climate-risk governance system.

Another consideration that is worth the time of the board and management of the banks is to embark on the review of the credit strategy, credit policy, and risk appetite for the bank. The reviews should be driven by climate considerations with the aim of embedding the same to the risk frameworks and capital-allocation processes within the bank. This may call for the introduction of a climate change or green lending policy of the bank that would cover most of the requirements of the guidelines.

Banks will need to build the capacity of their staff with the skills to enable them to mainstream climate risk considerations into all bank management and operational processes, including capital allocations, loan approvals, portfolio monitoring, and reporting.

Other than capacity building, banks need to develop methodologies and tools for assessing, managing, and reporting climate risk. The tools should be based on the best practices, for instance, the Task Force on Climate-Related Financial Disclosures (TCFD) which has been highly recommended by CBK as a way of the banks achieving the requirements of the guidelines.

Banks will now be required to carry out scenario analyses and stress tests of their portfolio with the aim of determining the possible losses that would emanate from climate risks. These efforts will require some technical knowledge on climate modeling as well as the identification of important climate hazards and the primary risk drivers by the industry.

This article was first published in Business Daily

The writer is a Global Climate Finance and Sustainability Expert