As the popular adage goes that “change is the only constant” and climate change fits the bill perfectly because every notable change in climate patterns brings a greater risk to financial stability. Hence it comes as no surprise that climate risk continues to be one of the top agenda for banking and financial institutions.
As regulators, banks and financial institutions are continuing to explore options to manage the financial risks emanating from climate risks in a better way. From a technology perspective regulatory technology (popularly known as RegTech) is emerging as a key technology enabler for managing climate risks. RegTech refers to the use of new technologies to solve regulatory and compliance burdens more effectively and efficiently.
But before we get in to how and where RegTech can help, there are some key constructs that need to be in place for financial institutions to enable a meaningful adoption of RegTech, namely:
- Establishing a climate risk enterprise strategy and a framework that is cognizant of geography climate change requirements, along with a robust operating model and measurable key performance indicators
- Establishing climate risk policies and procedures and communicating the climate change agenda across all levels in the organization
- Increased participation in green financing by focusing on a greener product portfolio such as green bonds and better priced loans to climate friendly counterparties.
- Establishing a RegTech adoption framework for climate risk management, including assessment and identification criteria’s for identifying climate risk areas that can be solutioned using RegTech
- Leverage existing RegTech solutions that can be extended to manage climate risk. For example, existing regulatory reporting solutions can be extended to manage climate risk-related regulatory reports.
- A robust reporting mechanism that provides insightful climate disclosures per requirements of internal and external stakeholders
Currently, climate risk management is grappling with a host of challenges that primarily include:
- Lack of holistic enterprise level view of the climate risk and its touch points on varied existing risk types
- Data availability. Data constitutes a key ingredient in climate risk management. While for traditional risk the historical data reflects the areas where organizations are more exposed, in the case of climate change there are multiple uncertain risk events that have a bearing on it.
- Data taxonomy. Currently, there are limited defined data standards and taxonomies for gathering data for climate risk management.
- Climate risk modeling capability. Expanding newer scenario variables related to climate risk for which projection has not been provided requires climate risk modeling capabilities.
- Individual counterparty analysis. This requires assessing current vulnerability of a counterparty given the impact of scenario variables and a counterparty mitigation and adaptation plan, which is not part of credit risk assessment today.
- Disclosure management. Banks and financial institutions are already reeling under huge regulatory disclosure requirements, and additional climate-related disclosures are going to add on to the existing workload.
While the existing challenges present a difficult path for effective climate risk management, there are areas where RegTech can ease the burden, such as:
- Leverage RegTech solutions for measuring and assessing the impact of climate risk regulations and policies on existing business processes, data requirements and disclosure management.
- Leverage machine learning-based RegTech to create hypothetical data sets that can be used as inputs in stress test models and to better assess the risk arising from extreme events.
- Leverage statistical tools, for generating climate-specific scenarios, conducting simulation and analysis, simulation for better stress testing to enhance risk management and a governance framework.
- Leverage RegTech data solutions for monitoring of climate risk and environmental data.
- Leverage artificial intelligence for deriving predictive insights from the climate reports generated for active decision-making.
- Expanding existing regulatory reporting by RegTech to standardize and incorporate climate related disclosures.
Since adoption of the Paris accord, there have been a slew of efforts from various regulatory bodies to improve understanding and adoption of climate risk management in banks and financial institutions. Such efforts from varied bodies include the Network for Greening the Financial System, Prudential Regulatory Authority, and the TCFD Framework (Task force on Climate Related Financial Disclosures), which laid a good foundation for effective management of climate risk.
Going forward in the post-pandemic world, efforts will need to be two-fold: one from the banks themselves to create a robust climate risk framework suiting their business strategy; and a second from the global regulatory bodies that will need to define climate risk guidelines for their specific geographies. Such efforts will eventually bring climate risk into the mainstream, along with other risk types. In this green journey, RegTech solutions are slowly but surely emerging as an essential partner that can address some of the existing gaps and e provide the required wings for mainstream adoption of this concept.