Climate (as well as other ESG topics) is high up on the agenda since countless years, including for financial institutions, and has now also reached the average investor’s attention and Swiss financial market regulation. In addition to long-established voluntary standards and private initiatives, FINMA plans to revise its circulars on public disclosure for climate-related financial risks of banks and insurers in line with these standards.

By Benjamin Leisinger (Reference: CapLaw-2021-05)

1) Background – Not a “New” Topic

a) International Background

Long before Greta Thunberg became a household name and green or ESG bonds made their way into retail investors‘ portfolios, political and business leaders around the world realized that climate and climate-related risks become increasingly important. In April 2015, the G20 Finance Ministers and Central Bank Governors asked the Financial Stability Board (FSB) to review how the financial sector can take account of climate-related issues. The FSB identified the need for better information to support informed investment, lending, and insurance underwriting decisions and to improve understanding and analysis of climate-related risks and, in December 2015, established the Task Force on Climate-related Financial Disclosures (TCFD) for this purpose. The initial members included representatives from various organizations, including large banks, insurance companies, asset managers, pension funds, large non-financial companies, accounting and consulting firms and credit rating agencies. In 2017, after numerous drafts and consultations, the TCFD released its climate-related financial disclosure recommendations designed to help companies provide better information to support informed capital allocation. The recommendations were endorsed by over 100 business leaders, including some Swiss large companies and financial institutions, from the beginning. To make the recommendations work in practice, the TCFD and the Climate Disclosure Standards Board (CDSB) in May 2018 announced the launch of a platform with relevant insights, tools and numerous resources on quality climate-related disclosures in line with the recommendations of the TCFD – called the TCFD Knowledge Hub (tcfdhub.org). According to the 2020 status report of the TCFD, 1,500 organizations globally, including over 1,340 companies with a market capitalization of USD 12.6 trillion and financial institutions responsible for assets of USD 150 trillion now support the TCFD.

This is just one example for an international initiative to address climate-related risks. Other initiatives include the Coalition of Finance Ministers for Climate Action, the International Platform for Sustainable Finance or the Network for Greening the Financial System (NGFS).

Some European jurisdictions, notably France or the UK, have issued regulation or regulatory expectations, respectively, for disclosing and/or managing the financial risks from climate change.

b) Switzerland

Also in Switzerland, climate and climate-related risks have been on the political and regulatory agenda for many years. After closely following the activities of the NGFS, a network of international central banks and supervisors committed to better understanding and managing the financial risks of climate change, since its launch in 2017, FINMA joined the NGFS in April 2019. In its Risk Monitor 2019, FINMA identified financial risks arising from climate change as one of the most important long-term risks and announced that it will refine its analyses of climate-related risks in the balance sheets of financial institutions and develop approaches for improved voluntary or regulated disclosure of financial climate risks. FINMA has a separate “dossier” on green finance on its website (https://www.finma.ch/en/documentation/dossier/dossier-green-finance/), showing how high it is on its priorities list. In June 2020, the Swiss Federal Council adopted a report and guidelines on sustainability in the financial sector. Welcoming the Swiss Federal Council’s initiative to examine the subject of sustainability and climate risks for the financial sector in further depth, FINMA already in June 2020 announced that it will address the subject of climate-related financial risks as part of its supervisory remit and review regulatory approaches for improved transparency regarding climate-related financial risks by major financial institutions.

2) FINMA’s Proposal on Public Disclosure of Climate-related
Financial Risks

From 10 November 2020 until 19 January 2021, FINMA consulted on a partial revision of the FINMA-Circulars 2016/1 and 2016/2 for public disclosure of banks and insurers, respectively. The proposed new disclosure requirements are largely based on the TCFD framework and build on, or continue, the initiatives and publications of FINMA in earlier years.

The proposal states to follow the principle of proportionality in regulation and only defines minimum requirements from a supervisory perspective. In addition, the scope of application is limited to supervisory categories 1 and 2 (i.e., for banks internationally active systemically relevant banks (G-SIB) and non-internationally active systemically relevant banks (D-SIB)).

a) How to Define Climate-related Financial Risks?

The FINMA proposal addresses the question of how climate-related financial risks should be defined: There is, however, no uniform definition of what a climate-related financial risk is. Typically, they are merely categorized into two types, also by the Basel Committee on Banking Supervision or the International Association of Insurance Supervisors as well as the TCFD. FINMA also follows these categories:

1. Physical risks: Due to climate-related natural disasters and gradual changes in the climate, there is a threat of increased damage to the economy. Climate change can thus lead, for example, to unexpected, increased loss amounts for insurance companies. Physical risks in the form of landslides or decreasing snowfall in mountain and ski resorts can affect banks’ mortgage portfolios and credit risks, even despite insurance coverage. Business interruptions at key service providers in exposed regions can cause cross-sector failures (operational risks).

2. Transition risks: Financial institutions may also be indirectly affected by intervening climate policy measures, changing customer preferences or disruptive technological breakthroughs. Changes in the framework conditions or new political requirements (e.g., CO² levies, emissions standards) can trigger asset price adjustments and be reflected in the market risk of banks and insurance companies. Credit risks can also be affected if stricter energy efficiency standards increase default risks in the mortgage business and at the same time cause losses in the value of real estate. The creditworthiness of companies in “unsustainable” sectors (e.g., coal and oil industries) may decline and counterparty default risks under credit risk may increase significantly. It cannot be ruled out that the markets will price in transition risks late, but then with strong adjustments. Corresponding losses may affect the profitability of banks (asset side of the balance sheet), asset managers and insurance companies, for example.

The FINMA proposal acknowledges that climate-related financial risks, hence, do not introduce a new risk category but rather are a new risk driver that can be captured and managed in the traditional risk categories such as credit, market, insurance or operational risks. In principle, financial institutions can build on their existing risk management.

b) Specific Aspects to be Disclosed

The proposal contained four general aspects that should be disclosed: governance, strategy, risk managements and relevant metrics. 

The governance aspect of the disclosure requests that the institutions describe how the board of directors exercises its overall supervision with regard to climate-related financial risks. According to FINMA, it is the management bodies and the responsibilities and reporting lines within the institution, which ultimately determine the quality and extent to which climate-related financial risks are addressed (“Tone From the Top”).

As to strategy, the identified “material” climate-related financial risks shall be disclosed, i.e., short-, medium- and long-term risks and their qualitative and quantitative impact on the business strategy, business model and financial planning. The disclosure must indicate which time periods are used as short-, medium-, and long-term.

The risk management related disclosure focuses on the process for identifying, assessing and addressing climate-related financial risks.

With respect to metrics, the quantitative information (ratios and targets) on climate-related financial risks and the methodology used to measure them shall be disclosed.

It follows from the principle-based regulation that the financial institutions intentionally retain sufficient flexibility to implement the disclosure in concrete terms, taking into account their size, complexity, structure, business activities and risks. The institutions themselves must then determine to a large extent how detailed their reporting should be or how it should be integrated into their annual report or the report on the financial situation, e.g., under the existing risk categories or as a separate chapter. The intention of FINMA is that the structures of current reporting, the conventional formats and data systems already used by the supervised entities should be leveraged and be used as a basis.

Where applicable, disclosure should be made at the level of the individual institution (stand-alone) and at the group consolidated level as for other risks. To avoid introducing additional burdens, the exceptions and exemptions applicable under current banking and insurance supervisory practice (e.g., reference options within group disclosures) also apply.

c) Criteria for Determining Materiality

The explanatory report of FINMA emphasizes that in banking and insurance regulation, disclosed information should be relevant/material. As a result, also as per the FINMA proposal, institutions are only required to disclose material risks. 

In the case of climate-related financial risks, however, the criteria and valuation methods used to assess the materiality of their climate-related financial risks must be disclosed in line with the TCFD framework in every case. To prevent institutions from making a blanket statement that they have no material risks, in FINMAs words “perhaps too quickly or without serious consideration of the issue”, this also applies in particular in the event that an institution classifies its climate-related financial risks as not material and thus not subject to disclosure requirements. According to the explanatory report, this special feature is justified in the case of climate-related financial risks in particular because there is as yet no firmly established, standardized or internationally recognized methodology for recording these risks. If such standards are recognized and defined in the future, financial institutions can simply reference them in their disclosure if applied by the respective financial institution.

Until then, according to the explanatory report, disclosing the criteria and valuation methods used, promotes comparability among institutions and market discipline in disclosure. 

3) Effects on the Covered Financial Institutions 

In the explanatory report, FINMA confirms that the majority of the covered institutions in Switzerland (supervisory categories 1 and 2) have already committed themselves to disclose their climate-related financial risks in accordance with the principles of the TCFD. Notwithstanding this, FINMA observed significant differences in the implementation and maturity of this disclosure. The new proposed minimum requirements in the FINMA-Circulars are, accordingly, mainly intended to lead to improvements in the quality of these disclosures and, in the longer term, to a certain degree of comparability of the information disclosed.

The proposals did not come as a surprise to the covered financial institutions. FINMA undertook a preliminary consultation with stakeholders and interested parties before. According to the explanatory report, in this preliminary consultation, various parties also called for the introduction of mandatory disclosure of quantitative information as being of particular relevance for investors. Because of such requests, FINMA now included these metrics (quantitative information (ratios and targets) on climate-related financial risks) in its consultation draft. FINMA, however, highlighted that institutions remain completely free to choose the methods, models and data used behind such quantification for the time being – i.e., likely until there is an established international standard.

4) Further ESG Topics Noted by FINMA

In addition to the disclosure of climate-related risks, FINMA – as a noteworthy side note – also mentions in the explanatory report for the consultation that it is concerned with the risks of so-called green-washing in the provision of financial services and distribution of financial products. According to FINMA, from the perspective of client protection, financial institutions must not mislead clients or investors with untenable or misleading promises about “green” features, for example in the case of investment products. Even without FINMA explicitly mentioning this, issues such as prospectus liability, contactual duties, general regulatory duties, and/or rules of the unfair competition act also demand that this is adhered to.

Benjamin Leisinger (benjamin.leisinger@homburger.ch)