Climate Risk in Banking Sector and Challenges

Introduction:

Climate risk is now categorized as one of the important elements in the strategic discussion among the Chief Risk Officers (CROs) in the banking industry.   Financial regulators across major markets are taking steps to ensure banks manage the credit risk associated with adverse climate changes.  Banks buckets the climate risk into two categories:- Physical risk, which refers to the monetary losses arises due to long term shift in climate or due to extreame weather change.  The transition risk, that happens due to changes in policy which can be a sudden change "disorderly" or a gradual change "orderly" transition. 

Financial markets regulators and Chief Risk Officers are very vocal unanimously among the board meetings that credit losses are the function of climate risk.  In other words, climate risk does impact the profitability of the financial institution.

What hindrances CROs face in making the banks resilient from climate-related risk?

Below are the three challenges that bank faces while projecting losses occurring due to  climate risk are discussed.

• Understanding the nature of emerging and evolving climate risk 

Banks must classify the risk arising as a physical risk which directly impacts the economy as a whole and affects the banks day to day operations such as extreme weather events which impact customers' flow of income, collateral values etc.   Climate risk also causes changes in the product mix in the market due to policy changes as part of the transition risk.

• Necessary but complicated way to measure the monetary impact of climate change on customers and overall portfolio

It is very important for the monetary authorities to underscore the importance of creating a framework and a clear roadmap for a financial institution to measure the impact of climate risk on a bank’s portfolio.   The framework must integrate the climate data into the loss forecasting approach, stress testing calculation and capital adequacy calculation engines.  

• Ensuring reliable climate data management for quantitative models and stress testing

One of the challenges in developing a quantitative approach in measuring the impact of climate risk on the portfolio is the quality and consistency of available climate risk data on carbon emission. Once the data is standardized there will not be any inconsistent corporate disclosure pertaining to the risk assessment and realizing the goals of net zero carbon footprint.

To meet the regulatory disclosure requirements such as Green Asset Ratio (GAR), it is critical to have the company level Scope 1, 2 and 3 carbon emission information integrated with the existing database of customer’s exposure information for credit risk calculation.  GAR provides critical measure and a perspective into a bank’s balance sheet, as the bank's large exposure to carbon-intensive industries carries a higher transition risk as compared to the one with a lower carbon-intensive industry.  These are quite complex challenges which currently regulators and risk practitioners are dealing with.

What is required to manage these risks?

Banks need following three actions to manage and incorporate climate risk the in the credit risk exposure calculation.

• Impact assessment on banks’ assets due to climate-related risk

• Aligning policies and strategies to climate-related risk

• Assessing Capital requirement framework in conjunction with Climate-related risk

Various country-specific and regional regulatory bodies have conducted assessments which act as a good starting ground for future studies.   Several studies have bought out two important results: 

a)     Credit losses tend to be lower if climate risk poses an orderly transition compared to a disorderly transition

b)    These assessments would have different top-down or bottom-up approaches along with assumptions regarding the financial information such as: whether the banking portfolio remains dynamic or static over time.

 What should be the approach?

Achieving maturity in climate risk capabilities is far more complex than meeting the existing regulatory compliance requirements.  Monetary authorities across regions have set a clear expectation that banks must invest in getting reliable climate data with good coverage across industries.  Chief Risk Officers and compliance managers should conduct the bank's self-assessment to ensure that the existing credit risk models, loss forecasting models and stress testing results are based on gold level climate data. 

CROs have to play a pivotal role to ensure that their organization reaches a certain level of maturity when dealing with climate risk impact calculation on banks’ expected credit losses.   This includes maturity across data coverage, data quality and clarity on both quality and quantitative approaches used in the calculation of credit risk at customer and portfolio levels. 

The various quantitative approaches to deal with climate data along with the credit risk model calculation will be discussed in my upcoming blog.