Guidelines on Management of Climate-Related and Environmental Financial Risks for Banks and Bank Holding Companies 2024

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RESERVE BANK OF MALAWI

BANK SUPERVISION DEPARTMENT GUIDELINES ON MANAGEMENT OF CLIMATE RELATED AND ENVIRONMENTAL FINANCIAL RISKS IN BANKS AND BANK HOLDING COMPANIES OCTOBER, 2024

2 TABLE OF CONTENTS PART I – BACKGROUND AND SCOPE..........................................................................................................3

1. INTRODUCTION ..........................................................................................................3
2. MANDATE...................................................................................................................3
3. OBJECTIVES................................................................................................................3
4. SCOPE OF APPLICATIONS............................................................................................3
5. DEFINITIONS...............................................................................................................3 PART II – APPROACH TO MANAGEMENT OF CLIMATE-RELATED AND ENVIRONMENTAL FINANCIAL RISKS .............................................................................................................................. 4
6. GOVERNANCE.............................................................................................................4
7. INTERNAL CONTROL FRAMEWORK............................................................................6
8. RISK MANAGEMENT PROCESS....................................................................................7
9. SCENARIO ANALYSIS AND STRESS TESTING ............................................................10 PART III - DISCLOSURE OF CLIMATE RELATED AND ENVIRONMENTAL FINANCIAL RISKS11
10. OBJECTIVES OF DISCLOSURES..................................................................................11
11. SCOPE OF DISCLOSURES...........................................................................................11
12. REVIEW AND REINFORCEMENT OF DISCLOSURES ...................................................12

3 PART I – BACKGROUND AND SCOPE

1. INTRODUCTION 1.1 The Registrar of Financial Institutions in Malawi (the Registrar) recognizes that climate-related and environmental events pose financial risks that can impact financial stability. The Registrar has issued these Guidelines to banks and bank holding companies to set out expectations of a prudent approach to climate related and environmental financial risks with a view of enhancing resilience of the banking sector arising from this threat.
2. MANDATE 2.1 These Guidelines are issued pursuant to Section 96 of the Financial Services Act, 2010.
3. OBJECTIVES 3.1 The objectives of these Guidelines are to: a. Ensure that banks and bank holding companies embed sound governance and risk management frameworks for climate-related and environmental financial risks within their overall risk management framework; b. Ensure that banks and bank holding companies conduct scenario analysis or stress testing to assess resilience of their business model and strategy to a range of plausible climate-related and environmental financial risk events; c. Outline broad principles which banks and bank holding companies may use to develop their climate-related and environmental financial disclosures.
4. SCOPE OF APPLICATIONS 4.1 These Guidelines apply to all banks and bank holding companies.
5. DEFINITIONS “Bank” has the same meaning ascribed to it in the Banking Act, 2010; “Bank holding company” refers to a body corporate that owns or controls at least two financial institutions one of which is a bank, whether the financial institution is a subsidiary or significant minority investment or interest of the body corporate;

4 “Climate-related financial risks1” refer to the potential risks that may arise from climate change or from efforts to mitigate climate change, their related impacts and economic and financial consequences. This may include damages caused by extreme weather events, losses as a result of long-term degradation following climate change, or a decline in asset value in carbon-intensive sectors; “Environmental financial risks” refer to risks that may arise from the exposure of financial institutions to activities that may potentially cause or be affected by environmental degradation (such as air pollution, water pollution, scarcity of fresh water, land contamination, desertification, biodiversity loss and deforestation) and the loss of ecosystem services; “Physical risks” refer to economic costs and financial losses resulting from the increasing severity and frequency of extreme climate change-related weather events, longer-term gradual shifts of the climate and environmental degradation; “Transition risks” refer to financial risks which can result from the process of adjustment towards a lower-carbon and more circular economy, prompted, for example, by changes in climate and environmental policy, technology or market sentiment and preferences. PART II – APPROACH TO MANAGEMENT OF CLIMATE-RELATED AND ENVIRONMENTAL FINANCIAL RISKS 6. GOVERNANCE 6.1 Role of the Board of Directors 6.1.1 The board has the primary responsibility to oversee effective management of climate-related and environmental financial risks in a bank and bank holding company. To fulfill this responsibility, the board shall: a. Ensure an appropriate collective understanding of and relevant expertise on climate-related and environmental financial risks at both board and senior management level; b. Approve and periodically review the strategy and risk management framework for climate-related and environmental financial risks and opportunities;

1 Climate-related and environmental financial risks can arise through physical risk and transition risk channels.

5 c. Set clear roles and responsibilities of board sub-committees, senior management, as well as internal organisational structures, as applicable, for the management of climate-related and environmental financial risks; d. Ensure that senior management is adequately and timely reporting to the board and board sub-committee on climate-related and environmental financial risks and opportunities; e. Ensure that relevant capacity development and training programs on climate￾related and environmental financial risks are conducted for the board and members of staff. 6.2 Role of Senior Management 6.2.1 Senior management shall: a. Implement climate-related and environmental financial risk management framework and policies; b. Review the effectiveness of the framework, policies, tools and controls at least annually; c. Provide periodic reports to the board on climate-related and environmental financial risks issues and opportunities as well as on the effectiveness and adequacy of the framework; d. Require that internal structures responsible for managing climate-related and environmental financial risks are clearly defined and have adequate resources, skills and expertise; e. Ensure adequacy and appropriateness of the training and capacity development plans. In particular, relevant frontline staff shall have sufficient awareness and understanding to identify potential climate-related and environmental financial risks; f. Ensure that material climate-related and environmental financial risk issues are addressed in a timely manner; g. Understand the potential impact of material climate-related and environmental financial risks on their business environment as well as the opportunities that may arise and consider them in their internal operations, strategies, business model, risk appetites and other decision-making processes;

6 h. Implement risk mitigation plans for managing impact of climate-related and environmental financial risks on internal operations and business models. 7. INTERNAL CONTROL FRAMEWORK 7.1 Policies and Procedures 7.1.1 A bank and bank holding company shall establish a climate-related and environmental financial risk management policy, which shall include, at a minimum: a. Roles and responsibilities of the board and senior management in climate￾related and environmental financial risk management; b. Roles and responsibilities of frontline staff, risk management, compliance and internal audit functions in climate-related and environmental financial risk management; c. A framework for identification, measurement, monitoring, and control of climate-related and environmental financial risks; d. Frequency of management reports to the board on climate-related and environmental financial risk management. 7.2 Internal Control 7.2.1 A bank and bank holding company shall put in place an adequate and appropriate internal control framework, across the three lines of defence, to ensure sound, comprehensive and effective identification, measurement, monitoring, mitigation and management of material climate-related and environmental financial risks; 7.2.2 A bank and bank holding company shall clearly define and communicate roles and responsibilities of business lines and the three lines of defence in relation to climate-related and environmental financial risks in the manner stipulated below: a. In the first line of defence, frontline staff shall undertake climate related and environmental financial risks assessment for instance during client on-boarding, on-going monitoring and new product approval processes;

7 b. In the second line of defence, the risk function shall conduct independent climate-related and environmental financial risks assessment and monitoring. The compliance function shall ensure adherence to applicable rules and regulations; c. In the third line of defence, internal audit shall perform regular reviews of the adequacy, appropriateness and effectiveness of the risk management and internal control framework for climate-related and environmental financial risks. 8. RISK MANAGEMENT PROCESS 8.1 Risk Management 8.1.1 A bank and bank holding company shall identify, monitor and manage all climate-related and environmental financial risks that could materially impair the financial condition, including capital resources and liquidity positions. 8.1.2 A bank and bank holding company shall ensure that the risk appetite and risk management frameworks consider all material climate-related and environmental financial risks to which they are exposed and establish a reliable approach to identifying, measuring, monitoring and managing those risks. 8.2 Risk Identification 8.2.1 A bank and bank holding company shall have a framework for identifying climate-related and environmental financial risks which shall at a minimum: a. Comprise a process for the identification of climate-related and environmental risks, deemed as material, at the level of counterparty, business lines, sectors and geographical locations as appropriate; b. Include definitions and thresholds for materiality to enable comprehensive assessment of climate related and environmental financial risks, bearing in mind that a risk management framework should enable the bank and bank holding company to recognize all material risks with an integrated firm-wide perspective on risk; c. Consider the potential impact of such material risks in the short-, medium-, and long term; d. Incorporate results of stress testing and scenario analysis;

8 e. Consider the impact of material climate-related and environmental financial risks in its internal capital adequacy assessment process; f. Ensure that material climate-related and environmental financial risks are duly assessed at origination stage and subsequent reviews of any lending or investment activities. The assessment shall include the ability and willingness of clients to manage and reduce the risks and the potential impact on the probability of defaults and the value of collaterals and investments. 8.3 Risk Measurement and Monitoring 8.3.1 A bank and bank holding company shall have a framework for measuring and monitoring material climate related and environmental financial risks which shall at a minimum: a. Include relevant risk indicators to categorise counterparties, sectors and geographical locations based on the extent of climate-related and environmental financial risks; b. Comprise an adequate risk monitoring process covering usage of qualitative and quantitative analytic tools as well as metrics to monitor relevant risk indicators and exposures against the overall strategy and risk appetite for climate-related and environmental financial risks; c. Ensure that the risk appetite framework incorporates relevant risk exposure limits; d. Encompass measures to encourage counterparties to provide relevant disclosures on climate-related and environmental financial risks. 8.4 Risk Mitigation 8.4.1 A bank and bank holding company shall have a framework for mitigating climate-related and environmental financial risks which shall at a minimum: a. Stipulate an appropriate risk mitigation plan where the risks are assessed as being material; b. Require regular engagements with counterparties posing material risk, to understand and monitor their risk mitigating plans.

9 8.5 Risk Management 8.5.1 A bank and bank holding company shall understand the impact of climate￾related and environmental financial risk drivers on their risk profiles, and ensure that risk management systems and processes for traditional risks consider material climate-related and environmental financial risks. At a minimum, the following risk management approaches shall be considered; i. Credit Risk a. A bank and bank holding company shall assess whether climate-related and environmental financial risks could reduce borrowers’ repayment ability or bank’s recovery of outstanding loans in the event of default. b. Incorporate material climate-related and environmental financial risks into the entire credit life cycle, including client due diligence as part of the onboarding process and ongoing monitoring of clients’ risk profiles. c. Identify, measure, evaluate, monitor, report and manage concentrations within risk types associated with climate-related and environmental financial risks such as exposure to geographies and sectors with higher climate-related and environmental financial risk. ii. Liquidity Risk a. A bank and bank holding company shall assess whether climate-related and environmental financial risks could cause net cash outflows or depletion of liquidity buffers, assuming both business-as-usual and stressed conditions (considering severe yet plausible scenarios). iii. Market Risk a. A bank and bank holding company shall understand how climate-related and environmental financial risk drivers could impact the value of financial instruments in its portfolio, evaluate the potential risk of losses from increased volatility of its portfolio, and establish effective processes to control or mitigate the associated impact. iv. Operational Risk a. A bank and bank holding company shall determine the potential impacts of physical and/or transitional risk drivers on its business continuity and consider the same when developing business continuity plans.

10 8.6 Risk Reporting 8.6.1 A bank and bank holding company shall have a framework for reporting climate￾related and environmental financial risks which shall, at a minimum, include periodic and timely provision of relevant information to its board of directors and senior management on material risks and opportunities. 9. SCENARIO ANALYSIS AND STRESS TESTING 9.1 The objectives of climate scenario analysis and stress testing shall reflect the entity’s overall climate risk management objectives as set by its board and senior management. These objectives could include, for example: a. Exploring the projected physical impacts of climate change and the transition to a low-carbon economy on the entity’s strategy and the resiliency of its business model; b. Identifying relevant climate-related risk factors; c. Measuring vulnerability to climate-related risks and estimating exposures and potential losses in the near- and long-term; d. Diagnosing data and methodological limitations in climate risk management; e. Informing the adequacy of the bank’s risk management framework, including risk mitigation options. 9.2 Scenario analysis shall reflect relevant climate-related and environmental financial risks for the bank and bank holding company. This should include the physical and/or transition risks that are relevant to a business model, exposure profile and business strategy. 9.3 A bank and bank holding company shall build sufficient capacity and expertise to conduct climate related and environmental risk scenario analysis that is proportionate to its size, business model and complexity. 9.4 A bank’s and bank holding company’s scenario analysis and stress testing shall at a minimum: a. Employ a range of time horizons, from short to long-term, in order to address different risk management objectives. For instance, shorter time frames may be used to analyse the crystallisation of risk within an entity’s typical business planning horizon at a lower level of uncertainty. Longer time frames, which carry higher levels of uncertainty, may be used to evaluate the resilience of existing strategies and business models to structural changes in the economy, financial system or distribution of risks;

11 b. Consider forward-looking information, in addition to historic data; c. Assess the impact of scenarios on their revenues, assets, significant counterparties, liquidity and capital positions; d. Consider a range of outcomes relating to different transition pathways and different channels including through physical and transition risks. PART III - DISCLOSURE OF CLIMATE RELATED AND ENVIRONMENTAL FINANCIAL RISKS 10. OBJECTIVES OF DISCLOSURES 10.1 A bank and bank holding company shall disclose, at least on an annual basis, in its annual reports, information on climate related and environmental financial risks it is exposed to, the potential impact of material risks and its approach to manage these risks. 10.2 The objectives of climate-related and environmental financial disclosures are; a. Manage investor expectations by disclosing the organization’s approach to climate related and environmental financial risks and opportunities, as well as its strategies for mitigation and adaptation; b. To inform lenders, insurers, investors and other stakeholders to appropriately assess and price climate related and environmental financial risks and opportunities; c. Enhance transparency around the potential impact of climate change events on the Bank and bank holding company’s operations, overall position and performance; d. Enhance confidence with stakeholders by demonstrating commitment to understanding and addressing climate-related and environmental financial risks in a transparent and accountable manner; e. Support the transition to a low-carbon economy and promote long-term sustainability by encouraging responsible business practices and investments. 11. SCOPE OF DISCLOSURES 11.1 A bank and bank holding company shall make disclosures on climate-related and environmental financial risks, in its annual report, on the following thematic areas: a. Governance Governance process regarding climate-related and environmental financial risks shall include the roles and responsibilities of the board and senior management. b. Strategy A bank and bank holding company shall disclose:

12 i. Its strategy for managing climate-related and environmental financial risks; ii. Climate-related and environmental financial risks and opportunities which have been identified over the short-, medium-, and long-term and the impact thereof on their strategy and financial planning. c. Risk Management A bank and bank holding company shall disclose: i. The processes for identifying, assessing and managing climate-related and environmental financial risks; ii. Elements which were considered in their assessment of the materiality of climate-related and environmental financial risks; iii. How climate-related and environmental financial risks are integrated in their overall risk management framework; iv. Information on the risks that the entity is exposed to and the potential impact of such risks. d. Metrics and Targets A bank or Bank Holding Company shall disclose: i. Key performance indicators and key risk indicators used with regard to climate-related and environmental financial risks for purposes of strategy setting and risk management; ii. Comparison of key performance indicators and key risk indicators against the internal targets; iii. Reference methodologies, definitions and criteria associated with the metrics and targets included in its disclosure. 12. REVIEW AND REINFORCEMENT OF DISCLOSURES 12.1 A bank and bank holding company shall regularly review and reinforce its disclosures, with a view to make them as insightful as possible. The disclosures shall take into consideration the evolving needs of stakeholders, regarding information on climate￾related and environmental financial risks and reflect the financial institutions’ evolving understanding of these risks.

13 Annex 1: Examples of climate-related and environmental financial risk drivers as drivers of other prudential risks Risks Physical Transition Climate-related Environmental Climate-related Environmental Examples of acute drivers: • Droughts • Floods • Storms • Heatwaves • Landslides • Wildfires Examples of chronic shift in patterns: • Extreme weather variability • Ocean acidification • Increasing temperature • Sea-level rises • Shift in rainfall patterns Examples: • Air pollution • Water pollution • Water stress • Land contamination • Degradation of soil quality • Desertification • Deforestation • Biodiversity loss • Resource scarcity Examples: • Policy, legislation and regulation changes: o Carbon pricing o Other green energy transition measures • Technological changes with shift to greener alternatives • Shifting market or customer sentiment with preferences for greener alternatives Examples: • Policy, legislation and regulation changes: o Pollution control o Pesticide control o Environmental conservation measures • Technological changes with shift to greener alternatives • Shifting market or customer sentiment with preferences for greener alternatives Credit The ability to repay or exposure at risk may be impacted, for example: • through a reduction in income following a climate event; • lower collateral valuations in real estate portfolios as a result of increased flood risk/ damaged properties/ lower yields in food crops. Transition measures may trigger substantial adaptation costs and lower profitability, which may lead to an impact on the ability to repay as well as lower collateral values. Market Physical risk drivers may lead to a change in market sentiment and be the cause for sudden repricing or changes in volatility. Transition risk drivers may affect highly polluting with high carbon emissions leading to a repricing of securities and derivatives related to such industries.

14 Operational Extreme weather events may cause damage to the properties of financial institutions, such as branches and data centres, leading to disruption in their operations. Shifting market sentiment regarding climate issues may lead to reputation and liability risks for financial institutions as a result of their financing of environmentally controversial activities. Other risks: Liquidity and Business model Physical risk drivers may affect counterparties and have them withdraw their funds to repair damages caused by such events. Transition risk drivers may affect the viability of some business lines and lead to strategic risk for specific business models. The liquidity of financial institutions may be affected by abrupt repricing of securities due to transition risk drivers. ………………………………. Dr McDonald M Mwale DEPUTY GOVERNOR, ECONOMICS AND REGULATION