By David Eacott – Head, Banking Supervision, MFSA
Climate Change will change the way we live our lives, our economy and decide the future of firms operating within it. The only thing that we can control is how we manage this transition. The more proactive governments and regulators are in managing the transition, the less costly it will be in the long term. Hence, prudential regulatory authorities have a significant role in helping firms to manage this transition so that it works for society as a whole. Helping firms, however, may sometimes mean pushing them to do more, and more quickly than they otherwise would. I set this message out to firms over a year ago, and we have followed up recently at the IFS Climate Change Conference.
A piece of work that the MFSA participated in, led by the European Central Bank (ECB), recently revealed some encouraging signs of progress in the banking sector since last year. Over 70% of boards have already concluded that climate change will have a significant impact on their businesses in the next few years. A lot of people in the banking industry tell me how proud they are to have avoided the extreme impacts of previous banking crises, and there’s certainly credit to be taken there. But when it comes to climate change, there’s no rear-view mirror. The focus needs to be squarely on the road ahead.
The prudential focus is intensifying. The legislative journey starts with ensuring effective disclosure of climate risk exposure. We, as regulators know that this is a challenge for firms. Banks, insurance companies, investment firms and other financial sector participants are likely to depend heavily on data supplied by their counterparts or customers in order to complete their own disclosure requirements.
In the future, regulators will use their intervention toolkit to mitigate risks from climate change. Regulators can mandate external reviews, place restrictions on businesses, add capital requirements or take enforcement action. In other words, regulators bring the costs of negative externalities created by non-compliant standards of an individual firm directly into its cost base. Those interventions are likely to be more costly to a firm than if they were to prepare early. A word of caution here: a recent survey by the European Central Bank has shown that over half of those with plans fail to implement them.
So what should boards and management be doing to prepare? I’ve grouped these preparations into three streams: strategic considerations, how to handle customers, and what to do with the internal functioning of the firm. These streams will require a concerted effort across the whole business.
- Strategically, regulators will be looking for evidence that banks and insurance firms have set limits on their potential exposure to climate related risks and monitor their actual positions against them.
- Retail customers will need to provide information on the energy or water efficiency of their property, and commercial companies supply chain information to satisfy a full environmental assessment of their business profile. Your customers might find requirements for new types of information quite difficult to adapt to. A business that works with its customers and future customers early on will find managing their expectations easier.
- Banks need to make sure that the risk, compliance and internal audit departments are positioned well for the change, and that reporting frameworks start to develop risk metrics and test data adequacy to support them. It is also important to train staff in customer-facing departments, integrate climate into staff’s KPIs, and develop stress scenarios.
The ECB has recently published a good practices guide which set out even more ideas on how firms can prepare.
Climate change is going to mean that some firms are likely to fail. The question a board needs to ask is whether you are doing enough to ensure it’s not yours. The challenge and cost of preparing is high, but the consequences of not doing so for your individual firm and for the customers and society you serve will likely be higher. In the same way that a disorderly and late adoption of climate change policies will be more costly for society, this also holds true for financial firms. Data is key - but if you don’t train your team and work with your customers, you definitely won’t be able to gather it.
I know this all feels rather daunting. But together the problem will be easier to solve and the MFSA remains committed to continue to play its part in the efforts ahead.