Climate risk will redefine the rules on cheapest to deliver collateral

Collateral trading markets face a large and looming challenge from climate risk accounting starting in 2021. What happens from there will require a substantial reworking on cheapest to deliver collateral rules across the industry.

Climate risk analytics will put a new risk weight on assets. Every bank is already familiar with the balance sheet taxes of the Liquidity Coverage Ratio, the Leverage Ratio and more. Climate risk adds another variable to the mix. As a colleague of ours said recently, when you apply the rules of climate risk to balance sheet costs, the cheapest to deliver may no longer be.

It will take real work for institutions to incorporate climate risk costs to their collateral preferences. The first task is determining the right climate risk analytics methodology, which include contenders like CLIMAFIN and MSCI’s Climate VaR. There is no practical way for each financial institution to maintain its own set of metadata on the variables that could impact securities prices from sudden and gradual climate change. As a result, banks and others will turn to vendors or government entities that offer support. This means a new vendor search in an untested area where requirements are still being developed.

Next, there are government stress tests on the horizon. The Bank of England has gone furthest in both announcing climate stress tests for 2021 and also providing some direction of what the analysis will entail. Wisely, the Bank of England says that banks will need to take their current portfolios and project them out 30 years with no presumption of change to see what happens. The Bank’s 2019 discussion paper says that:

This is because climate change, and the policies to mitigate it, will occur over a much longer timeframe than the normal horizon for stress testing. To make these scenarios credible and tractable, the Bank proposes that the [biennial exploratory scenario – BES] examine firms’ resilience using fixed balance sheets, focusing on sizing the risks and the scale of business model adjustment required to respond to these risks, rather than testing the adequacy of firms’ capital to absorb those risks.

This isn’t exactly realistic but should serve as a wake-up call when banks and the public find out how much climate exposure factors into financial stability and bank risk. The outcome of the tests will be a topic of conversation.

Just like in calculating cheapest to deliver collateral today, a new climate risk factor will impact the decisions of bank and counterparty collateral desks based on the perceived risk of the asset and the impact to the balance sheet. If climate-negative assets are weighing down a bank’s balance sheet then the bank will seek to move the asset along, and conversely will be less keen to accept an asset in house. Bank decisions on which assets are helpful or harmful to resource optimization will flow through to the rest of the collateralized trading industry in short order.

We recommend that financial professionals get smart about climate risk for their collateral-linked activities. Finadium subscribers can access our November 2020 report, Climate Risk Analysis for Treasury and Collateral Managers or watch our December 8, 2020 webinar on the same topic. We also recommend this recent speech by Fed Governor Lael Brainard, “Strengthening the Financial System to Meet the Challenge of Climate Change” – look for the section on Measuring, Modelling, and Managing Climate Risk in the Banking System. It may sound like a sleeper, but preparing for climate risk on the balance sheet and in collateral markets will take some time. The firms that prepare early will have greater success when risk analytics in collateral optimization becomes a reality in the short- to mid-term future.

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