Climate Risk Management - Futureproofing the Banking Sector

Mainstreaming climate risk management for the financial sector has emerged as a pertinent topic, with climate crisis fast turning into a financial crisis. Natural disasters cost about $18 billion a year in low-and-middle-income countries such as India through damage to power generation and transport infrastructure alone. These disasters also trigger wider disruptions for households and firms, costing at least $390 billion a year. Potsdam Institute’s study in 2024 claimed that the global economy was expected to lose 19% of global income in the next 25 years due to climate impacts, mounting to yearly losses of USD 38 trillion by 2050.

For the real economy players within the banking sector, the increased intensity and frequency of physical risks or natural hazards like floods, cyclones, droughts, heatwaves, have started to disrupt borrower-level business continuity and productivity. The transverse nature of climate-related financial risks is, therefore, making banks, insurers, and reinsurers less diversified, as it increases the impact or likelihood of climate events that were previously considered uncorrelated. A World Bank study analysed the Philippines banking sector data at regional level to look at impact of typhoons on NPA ratios between FY 2011 and 2018. It found that 1 percentage point increase in typhoon damage ratio would lead to an increase of 2.3 percent in the NPA ratio. This clearly hinted at the heightened credit and liquidity risks faced by banks and insurers, as climate events downgrade asset values.

All this has escalated apprehensions around the safety and poise of the sector and the broader financial stability implications for the banking system, leading to regulators and supervisors across the world fast-tracking climate regulation and responsibilities. Many have asked their significant banking institutions to undertake climate stress tests, as a part of their annual stress testing exercises based on NGFS scenarios. The objective is to understand the level of readiness in developing climate risk stress-testing frameworks that include climate risk transmission channels, and to assess coping mechanisms through hypothetical climate scenarios that are severe, but plausible.

Resultantly, with these exercises, banks are able to arrive at climate risk factors, climate stress test projections, and key risks from acute physical and transition risks. In addition, it also showcases banks' resilience to withstand extreme shocks, and ability to provision for adequate capital, at the same time, continue their lending activity.

The prevalent data gaps make such exercises rely on proxies to evaluate physical and transition risks. However, there is a rising expectation from regulators that going forward banks would need to obtain accurate and quantitative data from borrowers, thus, depend less on proxies to estimate exposures to carbon intensive sectors and transition to low carbon portfolios.

At an individual level, banks have proactively started adopting a three-phase strategy to integrate climate risks into mainstream operations and lending. This encompasses low carbon transition-planning, including baseline assessments like financed emissions and green asset ratios, transition planning that involves net-zero targets setting and adjusting sector investments for alignment, and risk integration that incorporates climate risks into existing frameworks and processes, enhancing risk management processes and practices like ERM, CAM, due diligence, credit ratings, and ICAAP for comprehensive risk management.

The regulator mandates on climate stress testing and banks’ own climate risk assessments have brought out the need to address inadequacies such as the lack of climate modeling expertise that is required to develop econometric credit risk modelling using climate-risk variables for sector-specific analysis or supply chain assessment. Deep diving into borrower-level data to identify, assess and measure climate vulnerabilities along with impacts is yet another complex task that needs specialised skills and processes. For example, navigating disaster risks and accurately pricing risk for pre-emptive debt needs processes to gather reliable, precise, and detailed quantitative data. This has compounded into a collective requirement to build and invest in adequate data integration systems and climate risk assessment tools that would lead to effective decision-making on assessing climate risks and analysing business opportunities for a low-carbon future.

In conclusion, climate events are impacting across the credit lifecycle, and integrating climate risk metrics into credit risk management is a humongous and specialised task for banks. With increasing regulatory pressure, not only do banks need adequate guidance on building climate expertise, and diversifying human capital to include climate risk professionals, but also gain access to appropriate climate data analysis tools to navigate through a profitable and sustainable, resilient future.