A consortium of experts focused on Environmental, Social, and Governance (ESG) issues is developing a risk-weighting methodology for banks to effectively manage assets impacted by climate change.
Green RWA is a dynamic association formed by key players in the banking, finance, and technology sectors. Their goal is to significantly impact environmental sustainability by enhancing how banks assess climate risk and adjust their capital allocations accordingly.
Adrian Sargent, the treasurer of Green RWA and founder of ESG Treasury, outlines the association’s mission in their recent publication, “How Banks Can Save the Planet.” He emphasizes that financial services play a crucial role in advancing toward a sustainable economy. “This paper serves as a call for collaboration and collective intelligence to guide the market in the right direction.”
In response to the Bank of England’s 2019 discussion paper on environmental stress testing, Sargent argues for the necessity of banks holding adequate capital reserves against climate-related risks. This requires them to conduct thorough risk assessments across their operations.
The methodology proposed by Green RWA involves applying a capital charge to bank loans that reflects both ‘transition’ risks—risks associated with shifting to a greener economy—and ‘physical’ risks, such as those from extreme weather events. This approach mandates that banks evaluate the broader consequences of their lending practices.
The calculation framework outlined by Green RWA incorporates three main components: the standard risk assessment, an evaluation of the risks linked to the transition toward sustainability, and a consideration of physical risks like flooding. “We suggest that companies modify traditional risk calculations by adding transition and physical risks, thereby creating a new asset risk weighting framework,” says Sargent.
This method may lead to an overall increase in the amount of capital banks hold, as certain capital requirements rise while others may decrease. Additionally, banks that proactively lend to companies engaged in environmentally friendly practices could benefit from favorable calculations in their assessments.
Despite its seemingly straightforward premise, the intricacies of this methodology are being meticulously refined and reviewed by mathematician Professor Josselin Garnier, aiming to ensure that it aligns seamlessly with banks’ existing data systems and reporting mechanisms.
When asked why banks have not yet embraced this accessible and potentially straightforward approach, Sargent notes, “Having worked with banking institutions for many years, I’ve observed that guidance from regulators is highly valued. The Bank of England has openly discussed this issue, but without setting specific regulations. However, this evolving public interest is prompting some banks to take proactive measures.”
Green RWA is committed to making their model freely available, reflecting their aim of fostering dialogue and collaboration on this vital issue. “We hope that our approach and discussions will attract regulators’ attention. The sooner this dialogue is integrated into formal regulatory discussions, the sooner banks will begin to observe these requirements as standard practice.”
But can we realistically expect banks to engage with this ostensibly altruistic initiative? Sargent believes that raising awareness within banks about their portfolios can lead to more informed decision-making regarding climate risks. “If banks neglect to adopt this framework, they might misjudge their risks, which can have significant repercussions.”
He continues, “Those who take this issue seriously will likely influence their clients to transition sooner, as evidence shows that earlier action often results in reduced costs.”
With the significant variability in approaches to addressing climate risk, is it feasible to standardize the Green RWA methodology across the banking sector? “That presents a challenge,” Sargent acknowledges, “mainly because there is currently no universal climate change data source established by regulators.”
Sargent highlights that the Bank of England has left it to individual banks to determine which climate data to use, allowing for a degree of flexibility in their modeling. Nevertheless, he advocates for a standardized set of variables akin to credit risk standards to maintain some level of consistency among different banks.
Green RWA is working on a second paper, expected for release in late Q4 2020, which will include an enhanced Climate-Extended RWA model and more sophisticated portfolio analysis, offering banks insights into the capital implications of their climate exposure.