Risks of investing in the financial sector. Valuable Insights

The recent devastating floods in Austria and other European countries, exacerbated by climate change, highlight the substantial risks that a warming planet poses to the financial sector in the European Union and globally. These risks fall into three categories: physical risks from intensifying extreme weather events, transition risks from the shift to a low-carbon economy, and risks stemming from financial institutions’ current inability to effectively manage climate-related threats.

In the sections that follow, we’ll delve into the specifics of these risks as they pertain to investing in the financial sector. We’ll examine the potential impact and likelihood of a global financial crisis triggered by the escalating effects of climate change.

You can read the full article here >>>

Risks for the global financial sector due to climate change

Climate change has the potential to significantly impact the global financial system, and there are concerns that it could contribute to a banking crisis in the coming years. Below we highlight some key points to consider:

• Increased Frequency of Crises: The recent research prepared by Yale University suggests that climate change could increase the frequency of banking crises by as much as 248%. This is due to the heightened risk of extreme weather events and their economic impacts.
• Systemic Financial Risk: Climate change is increasingly seen as a systemic financial risk.?The unpredictability of climate– related disasters can disrupt markets and economies, leading to financial instability.
• Regulatory and Policy Responses: There is a growing recognition that the financial system needs to adapt to these risks.?This includes integrating climate risk into financial decision-making and improving the resilience of financial institutions.

Let’s analyze the impact of the recent rainfall in EU countries on the financial sector

Increased Rainfall and Flooding: Climate change is leading to more intense rain storms and floods in Central Europe, including Austria. According to the climate scientist at ETH Zürich: “on average, the intensity of heavy precipitation events increases by 7% for each degree of global warming. We now have 1.2C of global warming, which means that on average heavy precipitation events are 8% more intense.” This extreme weather has resulted in large-scale flooding, damaged homes and infrastructure, and evacuations. The ETH Zürich station data indicates that bursts of September rainfall have become heavier in Germany, Poland, Austria, the?Czech Republic , Hungary, and Slovakia since 1950.

Impact on the Financial Sector: In our view, such climate-related events pose significant risks to financial stability in the European Union. A report by the European Commission highlights these risks. For instance, 22% of European banking exposures could be exposed to high physical risk mainly due to fires and heatwaves. Furthermore, 10% of bank balance sheets exposed to firms with varying emissions efficiency could be vulnerable to credit risks.

If we analyze only the most recent, the September flooding event in Europe, we notice that the flooding has had a significant impact on the region, with damage to infrastructure projected to reach a combined $10 billion in the Czech Republic and Poland alone. The EU has promised $11 billion in emergency repair funding.

Despite the devastating effects of the flooding, the profitability of banks in the flood-affected regions is expected to remain robust. However, even if the impact of floods on the banking sector is currently limited, climate change can amplify flood-related losses, potentially lowering bank capital ratios in the long run.

It’s important to note that while the immediate financial impact on banking capital may be limited, the long-term effects of increased flooding due to climate change could have a more significant impact on the banking sector.

Cumulative loan losses due to flooding in September

European banks may face significant cumulative loan losses due to the flooding in September 2024, particularly if the disaster leads to severe pressure and rapid growth in problem loans. Moody’s has warned that these banks may not have sufficient provisions for property loan defaults.

The exact magnitude of the potential losses is difficult to quantify, but research by the IMF suggests that banks’ capital losses could be in the range of 40-110 basis points under certain economic disruption scenarios. This is higher than some initial estimates of 30-60 basis points.

A key factor will be the loan loss reserve levels of the banks. Moody’s analysis applied a reserve level of 40%, which is the average reported by large European banks over the last five years. However, the actual required reserves may be higher due to the severity of the flooding and its impact on the economy.

Historically, natural disasters have been shown to increase the ratio of system-wide non-performing loans by between 0.5% and 0.6% two to three years after the event. This could indicate a long-tail risk for European banks in the wake of the 2024 flooding.

The European Central Bank has noted that total economic losses from extreme events like flooding amounted to 1% of GDP in the euro area in 2019, and these costs are expected to rise over time without action. This trend could exacerbate the cumulative loan losses faced by banks.

The flooding’s impact on small and medium-sized enterprises (SMEs), which are a crucial part of the European economy, will also be important to monitor. Localized data from three European countries has shown that flooding can have a significant financial impact on SMEs, potentially leading to increased credit risk and loan losses for banks.

Additional Risks: Climate risks can affect business performance through asset damage, operational disruptions, and reduced cash flows, ultimately impacting the ability to repay loans. The financial sector is not yet well equipped to identify, manage, and disclose climate-related information, in our view. Climate risks will cause financial instability and irreparable socioeconomic damage if no action is taken soon.

In our view, the global financial and insurance sector has significant negative exposure to the unpredictable events propelled by the climate change.

Physical Risks: Extreme weather events like floods, wildfires, and hurricanes can destroy property and physical capital, affecting GDP growth. Long-term shifts in climate can lead to the closing of retail branches or facilities. Rising sea levels and increased frequency of natural disasters can lower the value of assets in those regions, and increase the default risk of loan portfolios.

Transition Risks: The shift to a low-carbon economy can impact certain economic sectors more than others, affecting their financial performance and the stability of the financial system. Successive storms may delay economic recoveries and deter private investments.

Systemic Risks: Climate-related events can affect financial system resilience, leading to a self-reinforcing reduction in bank lending and insurance provision. The mounting impacts of climate change pose substantial risks to the stability of the financial system and the entire economy.

The probability of the global financial crisis due to climate change

The probability of a global financial crisis driven by climate change events in 2025-2026 is difficult to quantify precisely due to the complexity of factors involved. However, there are several indicators suggesting that the risk is significant:

• The World Bank notes that climate risk could cost the global economy $23 trillion annually in just 25 years, slashing global economic growth by between 11% and 14%.
• Chatham House warns of the severe economic and financial consequences of climate change, particularly given the enormous shortfall to date in spending on adapting to its impacts.
• The frequency of climate-related disasters has increased by an order of five over 50 years, according to the World Meteorological Organization.

As for estimating this probability, several approaches can be taken:

• Scenario analysis is considered a key tool in assessing the financial risks posed by climate change. This involves modeling different climate scenarios to estimate the potential financial impact.

• Climate VaR (Value at Risk) is a valuable tool for assessing and managing the financial risks associated with climate change. It quantifies the potential loss (or worst loss) with a given probability over a specific time horizon.
• Total climate financial risk can be calculated as the sum of transition risk (from the business-as-usual pathway to a low-carbon pathway) and physical risk (at the low-carbon pathway).
• The IMF recommends first assessing which climate hazards are most relevant for a country, and then analyzing the exposure and vulnerability of different sectors to these hazards.

Illustration of the Transmission Channels for Shocks from the Real Economy to the Financial Sector

Should investors have exposure to the financial sector in their portfolios

As we mentioned above, climate change poses significant risks to the financial sector, particularly to banks and insurance companies, and these risks will likely increase in 2025 and 2026 as the impacts of climate change become more pronounced. Both physical risks, such as more frequent and severe weather events, and transition risks, such as changes in policy and market sentiment as the economy shifts towards lower carbon emissions, can affect the financial sector.

For banks, climate change can increase the likelihood and impact of events that were previously considered unrelated, making banks less diversified. Climate-related risks can also affect the value of assets used as collateral for loans and the income borrowers use to repay loans, which can impact the stability of banks. Additionally, banks may face risks from climate-related litigation and changes in regulatory requirements.

Insurance companies are also heavily exposed to climate-related risks. More frequent and severe weather events can lead to higher claims, and insurers may need to reassess their risk models and pricing strategies. Insurers may also face risks from changes in investment portfolios as assets become more or less valuable due to climate-related factors.

Despite these risks, there are also opportunities for investors in the financial sector as the economy transitions to lower carbon emissions. Sustainable finance, which takes into account environmental, social, and governance (ESG) factors, can help direct capital towards more resilient investments and support the transition to a low-carbon economy. ESG factors are becoming increasingly important in the financial sector as they can impact financial performance and help identify and manage risks.

To navigate these risks and opportunities, investors will need to carefully assess the exposure of financial institutions to climate-related risks and their strategies for managing these risks. This will involve analyzing the financial institution’s business model, risk management practices, and governance structures, as well as its ESG performance. Investors will also need to engage with financial institutions to encourage better disclosure of climate-related risks and opportunities and to support the development of more resilient business models.

In terms of specific investment strategies, investors may consider the following approaches:

• ESG integration: Consider ESG factors in investment decisions to help identify and manage risks and opportunities.
• Thematic investing: Invest in themes related to the transition to a low-carbon economy, such as renewable energy , energy efficiency, and sustainable infrastructure.
• Impact investing: Seek to generate both financial returns and positive environmental and social impacts.

Investors will also need to work with policymakers and regulators to support the development of more resilient financial systems. This will involve advocating for better disclosure of climate-related risks, the development of more robust climate risk assessment methodologies, and the creation of incentives for financial institutions to manage climate-related risks effectively.

In our view, while climate change poses significant risks to the financial sector, there are also opportunities for investors who can navigate these risks and support the transition to a more resilient and sustainable financial system. This will require careful analysis, active engagement, and a commitment to responsible investment practices.

When assessing the impact of a climate shock event on a bank, the following KPIs are particularly important:

Probability of Default (PD): This measures the likelihood that a borrower will default on its loan obligations due to the climate shock event. A higher PD indicates greater credit risk.

Asset Valuation: Changes in the valuation of assets and liabilities on a bank’s balance sheet due to the climate shock event can significantly impact its financial health. Financial metrics such as stock market indicators can be used to assess these changes.

Exposure Granularity: Banks and supervisors need to determine the level of exposure granularity when estimating the implications of climate risk drivers. This involves assessing the specific exposures of different assets and portfolios to the climate shock event.

Climate-Adjusted Expected Default Frequency (EDF): This metric takes into account the impact of both physical and transition climate risks on a company’s credit risk. A higher climate-adjusted EDF indicates greater credit risk due to the climate shock event.

Materiality Assessment: This involves identifying the climate drivers that are likely to have the most significant impacts on the bank’s portfolio. A materiality assessment can help banks focus their resources on the most critical climate-related risks.

In addition, we would also highlight the Capital Adequacy ratio, Loan-to-Assets ratio, Net Interest Margin, Loan-to-Deposits ratio, and Efficiency ratios in combination with stock market multiples, like P/E, and P/BV.

By focusing on these KPIs, investors can better assess the impact of climate shock events on a banking institution and make educated investment decisions. Climate scenario analysis is a useful tool for quantifying these potential exposures and assessing the resilience of the bank’s portfolio to different climate scenarios.