A Blueprint for Climate Risk Management

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

Effective risk management requires firms to stress test the trading book to assess the full gamut of possible risks, including the impact of climate-related shocks. The challenge is to model the range of scenarios using a consistent methodology. That’s why ISDA has developed a conceptual framework for climate scenario analysis in the trading book, which provides a blueprint for banks to estimate the impact of future climate events on traded assets.

The framework is the latest step in industry efforts to manage climate risk in the financial system. Financial institutions and public sector bodies have already made good progress in assessing the effect of climate change on banking book assets, such as deposits and loans. For example, scenarios developed by the Network of Central Banks and Supervisors for Greening the Financial System have been used to model the expected impact of defined physical and transition risks by the end of the century. Many other entities, including the European Central Bank and the Bank of England, have also produced their own climate scenarios.

As an ISDA survey revealed last year, banks are now prioritizing the development of climate scenario analysis in the trading book, but they face several challenges, including a lack of standardized methodology and a scarcity of reliable data. To build consensus on the method and approach, ISDA has worked with Deloitte and more than 30 banks to develop a framework for the trading book, as well as define a set of issues to support the design and implementation of scenarios.

This is challenging territory for two key reasons. First, existing climate scenarios have typically taken a long-term view on how held-to-maturity assets might be affected by certain shocks in the future. Trading book assets require a different approach, and the conceptual framework is designed for scenarios with short-term horizons running to days, weeks and months rather than years or decades. Second, while existing climate scenarios tend to focus on the macroeconomic hit, such as a decline in gross domestic product, banks need to go a step further to model the impact on market risk. Translating a macroeconomic shock into market risk parameters is a recognized part of scenario analysis, but this is particularly important when it comes to climate risk because there is less historical data available to determine the market risk impact.

Up until now, many banks have taken the scenarios developed by the NGFS and other agencies as a starting point and modified them for the trading book, but the conceptual framework provides a valuable starting point for the development of a more robust and consistent approach to trading book scenarios. It maps out the specific stages of scenario design and implementation, from defining the objective and climate narrative to deriving data and the generation of market risk factors.

Implementing this framework in a risk-appropriate way will be no small challenge and will require extensive testing and validation. ISDA has been working closely with both the participating banks and public sector bodies like the NGFS to share best practice and fine tune the approach. This culminated in a constructive workshop in London and the subsequent publication of the conceptual framework. We’re now getting started on the next phase of this important work and will further build out the framework and develop scenarios in the months ahead.

Read the ISDA report, A Conceptual Framework for Climate Scenario Analysis in the Trading Book

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