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The use of credit risk weights for climate-related purposes

This Bulletin article discusses the use of credit risk weights for climate-related purposes.

Saralee King, Chris Leaney and Richard Downing

Executive summary

The Reserve Bank of New Zealand’s prudential framework includes a range of requirements to ensure banks are resilient in the face of shocks to support financial stability. Minimum capital requirements are a central component of this approach and are in the process of increasing following the 2019 Capital Review.

As part of the prudential framework, banks must complete a number of processes in their calculation and management of regulatory capital. The use of risk weights, where the dollar value of an exposure is adjusted to reflect financial risk, is a central part of the prudential framework and is an independent function overseen by the Reserve Bank.

Risk weights are used for the purposes of ensuring banks accurately and appropriately manage their risk. Risk weights are not designed to encourage or discourage banks to undertake any particular type of lending to specific sectors or activities.

The aim of the approach to risk weights is for exposures with greater amounts of financial risks, including any risks related to climate change, to face a higher risk weight than those with lower financial risk (all else equal). This then results in higher capital requirements, driven by higher risk weights, for exposures with higher risk. As a result, risk weights are one of a wide range of factors that influence bank funding costs and ultimately the interest rates faced by borrowers.

Because higher risk weights attract higher capital requirements, when risks are accurately measured and reflected in a bank’s risk weighted assets, the bank’s balance sheet is in a stronger position to absorb losses. This makes the individual bank more resilient in a stress event and increases system-wide financial stability, as that individual bank is less likely to fail and therefore less likely to transmit the costs of failure across the rest of the inter-connected system. These contagion effects can have large economic costs. Accurately measuring and managing financial risks is therefore a vital part of promoting the stability of the banking system and supporting the financial stability objective.

Climate change and the associated physical and transition risks, collectively climate-related risks, pose risks to the stability of the financial system through various channels. To meet our financial stability objective, it is therefore important for us to take account of the current and future impacts of climate change. Our approach to climate-related risks is set out in our 2021 Climate Changed report. That report lays out more detail about how and why climate is core to our mandate, the risks of climate change to our core functions and our climate change strategy. The topics covered in this article sit firmly within this wider approach.

There are mechanisms to incorporate climate-related risks within the approach to risk weights for credit risk, one type of financial risk, for both the internal ratings-based and standardised approaches. All of these are clearly linked to the level of credit risk to the bank arising from climate change, through the impact on a bank’s likelihood of making a loss on their assets. Nevertheless, accurately including these climate-related risks into the credit risk weights that banks use is not straight-forward and up-to-date, comprehensive data is missing in several areas. We consider enhancing climate-related risk capabilities along with the quality and availability of consistent data as priorities for banks to promote better management of climate-related risks.

The understanding of how climate-related risks impact financial risk, including credit risk, (and therefore capital requirements) is fast-evolving globally, and we will continue to evaluate the effectiveness of our approach. We will also continue working with our fellow Council of Financial Regulators members and international peers to keep abreast of developments and what constitutes best practice in this space. When considering any future changes to the approach to setting risk weights, we will ensure any changes are data-driven and explicitly linked to financial risk, rather than for the purposes of achieving other policy objectives unrelated to the management of financial risk.

We will also continue to employ the other tools available to us to help enable all prudentially regulated entities to manage climate-related risks to the financial system, noting our efforts comprise one part of the system-wide approach to addressing the current and potential impacts of climate change.

After setting out some background, this Bulletin is split into 4 main sections:

  • providing an overview of the Reserve Bank’s general approach to credit risk weights
  • explaining what climate-related risks are and their links to credit risks to individual banks and financial stability at a system-wide level
  • outlining how the Reserve Bank’s credit risk weights framework currently incorporates climate-related risks within its general approach to credit risk, and
  • outlining other tools that the Reserve Bank uses to help entities manage climate-related risks to financial stability.