Current regulation stipulates that material risks should be governed in a way consistent with sound risk management. As climate-related risks may manifest itself through existing risk types that potentially result in significant financial losses, banks should manage these risks in a way that reflects an appropriate application of the applicable regulation. In her capacity of prudential supervisor, DNB therefore expects banks to incorporate climate-related risks into their governance and risk management arrangements in line with the principle of proportionality.
Incorporating climate-related risks in banks’ risk management is in line with CRD IV, which in Article 74 stipulates that banks must have in place robust governance arrangements, including effective processes to identify, manage, monitor and report the risks to which they are or might be exposed to. This provision has been implemented in, among others, section 3:17 of the Wft, which requires sound business operations in which financial risks are managed.
Section 24a of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels – Bpr), which expands on Section 3:17 of the Wft, also requires a bank to have in place robust, effective and comprehensive strategies and procedures to ensure that the level, composition and division of its own equity capital are in accordance with the size and the nature of the risks it faces not only in the short term, but also in the long term. In view of the long-term nature of climate-related risks, DNB considers this provision applicable with respect to climate-related risks.
Articles 23 and 24 of the Bpr provide a more detailed explanation of this within existing governance, risk management and reporting processes. If climate-related risks are regarded as not material, for instance because an individual bank is not or could not be exposed to them, then an analysis describing why they do not impact its risk profile would be sufficient. Institutions are expected to be transparent about this in their reporting (e.g. in their ICAAP submission).
Climate-related risks can translate into material financial risks for banks through two main channels of transmission: physical risk and transition risk. Both physical risks and transition risks may materialise on the asset side of a bank’s balance sheet, in relation to the activities it carries out.
- Physical risk - Exposures are vulnerable to the physical consequences of changing weather, such as damage to real estate (collateral), or write-downs of companies whose property or processes are exposed to physical consequences of climate change.
- Transition risk - New climate policies7 (resulting in increasing regulation and standardisation), technical developments and/or shifts in consumer preferences may affect businesses’ market value or creditworthiness. This means the risks associated with the transition to a low-carbon economy could lead to a writedown of loans to and investments in companies.
Failing to address these risks can also result in reputational and legal risks, which can materialise on both the asset side (e.g. pressures leading to early termination of a loan agreement) and the liability side of the balance sheet (e.g. many depositors who rush to withdraw their money).
Climate change poses new challenges to the risk management of banks. Both physical and transition risks can be characterised by significant uncertainty and nonlinearity, while their probability of occurrence may not be reflected in historical data. These challenges thus warrant timely and concerted actions by banks, but also by the wider private and public sector.
We have set out these risks in detail in our report Waterproof? An exploration of climate-related risks for the Dutch financial sector (2017).
DNB's report Values at risk? (2019) shows that other ecological and social risks (e.g. loss of biodiversity) may also be relevant to the financial sector, as these can translate into financial risks through the same channels (physical and transition). We encourage institutions to take a holistic approach to environmental, social and governance risks when integrating them into their risk management framework.