9th September 2021
Financial institutions across the world have experienced huge disruption from Basel IV’s Fundamental Review of the Trading Book (FRTB). Basel IV, agreed back in 2017, will finally come into effect in January 2023. Yet financial institutions already need to prepare for what comes after that. The next Basel Accord – Basel V – will be focused on climate risk and, if you thought Basel IV was a lot of work, wait until you see what’s coming down the line.
Financial institutions need to think ahead to Basel V as both governments and financial sector firms emphasise that the next big wave of regulation will result in fundamental changes in business practices. These changes will result in huge disruption, re-pricing and re-ranking of asset valuations, radically transforming the business landscape as we know it.
The good news is that financial institutions that plan ahead and get a solid structure in place to manage their climate risk will be in a strong competitive position by the time that Basel V arrives. As in all change scenarios, there can be as much upside opportunity as there is downside risk. The skill is judging how to get on the upside path.
We can already start piecing together the roadmap to Basel V. Negotiations have been taking place on transition paths to net zero in the build-up to the United Nations Climate Change Conference – otherwise known as COP26 – in November 2021. We also see ongoing alignment of the G7, G20, and a larger group of central banks under the Network for Greening the Financial System (NGFS) and Basel IV requirements.
At COP26, we expect to see nearly 200 countries start to align their plans around de-carbonisation timeline commitments and international standards for carbon pricing and tax. These are all designed to achieve net zero outcomes faster than otherwise possible. This will stimulate activity around sustainable finance and help inform the new text for the future Basel V standards.
The outcome will be a new world order where financial data and controls meet environmental data and controls. This combination will require a business-wide mesh of risk and operational controls where all lines of business and group functions will change. Basel V will, therefore, be climate risk-focused and have as much, if not more, of a disruptive effect on banks than Basel IV’s FRTB is right now.
Basel V will create overwhelming complexities for financial institutions’ data teams. To remain compliant in the future, they need to understand how to model unstructured, non-financial data, most of which they have little or no experience in managing. This data will be costly to obtain, manage, process and act upon, putting incredible pressure on already tight margins.
To succeed, financial institutions will need access to accurate data. There is a whole discussion going on right now about how to address open climate data in order to accelerate the transition to a net-zero carbon (and other greenhouse gas) emissions environment globally. Companies will then need automated support in the form of artificial intelligence (AI) and machine learning (ML) to crunch the numbers. They will also need new specialist skills in risk model development, and expert subject matter analysts to make sense of it.
Fast and Large: Financial institutions will urgently need to obtain climate risk data rapidly and at huge scale. This will require an immense amount of storage space.
Alternative: While financial institutions are used to crunching financial data, climate risk data is very different. It’s unstructured, non-financial, environmental-based data at both a micro and macro level.
New Models: Data will be pushed through specialist physical and transition risk models. This will require massive at-rest storage and more-massive computing power.
Translation into Financial Format: Climate risk data will need to be interpreted and structured into financial scenario data. Again, this will take a great deal of storage and computation combined with skilled humans that can bridge the domains of climate and finance.
Scenario Runs: Environment data needs to be processed through existing risk infrastructure scenario engines and reporting. These reports will re-use all of the data, models and processes already developed for prior Basel changes.
Embedded across the Business: All data must be embedded in real-time risk and operational controls so that targets are met.
To handle the above and remain compliant – and therefore competitive – financial institutions must instil a data-led culture across the whole business. From the boardroom to the store cupboard, corporates will need to account for their carbon footprint.
Act now, not tomorrow: Basel V may appear too distant to many, and non-existent to some for now. But this is not a drill – financial institutions need to act now! There’s no time to wait for the market to move; the most competitive, future-proof organisations will be those who move ahead of their rivals. The later they leave it, the more it will cost them in the long term. Some may even fail as businesses due to inertia.
Financial institutions must also understand what steps they need to take to become a data-led business ready for Basel V and the climate risk data demands of the coming decade.
Seismic shifts are afoot in financial services as institutions seek to navigate the data-driven, digital revolution that is disrupting and transforming the sector. It is key to partner with experts who can help you make sense of it all. At First Derivative, we use data intuitively to help companies solve the toughest of operational, data and technology challenges in the era of climate risk reporting. With us, you can prepare for a changing world and in so doing simultaneously address many of the unknowns of Basel V and turn a very real threat to your margin and viability into a substantive competitive advantage by investing in data-led carbon modelling and risk management.
For ongoing information on how to prepare for an era of climate risk reporting, contact us. And if your organisation is struggling to understand what climate risk means for you in the coming years, do please get in touch.
|Johnny D Mattimore
Managing Director, Global Head of Risk & Sustainable Finance