Banks must learn to factor in climate risk

Kasturi Das |Kaushik Ranjan Bandyopadhyay | Updated on: Jul 29, 2022
Banks are slowly waking up to the risks posed by climate change to businesses and lending

Banks are slowly waking up to the risks posed by climate change to businesses and lending | Photo Credit: sarayut

Banks need standardised industry models, and skilled professionals, to embed climate risk into enterprise risk management 

On July 24, RBI Governor Shaktikanta Das announced that the central bank will soon issue a consultation paper on climate risks for banks and financial sector.

The intent is to seek stakeholder views and suggestions for a more informed and measured approach towards preparing the banking sector to internalise climate risk.

The endeavour is in line with RBI’s April 2021 decision to join as a member of Network for Greening the Financial System (NGFS) — a coalition that brings together central banks and supervisors working on climate and green finance issues from across the globe.

Climate risk, even a decade back, was not a prerogative of either the policymakers, regulators, or the businesses. However, with the countries becoming increasingly exposed to climate related catastrophe (like wildfires in California, Australia, and Brazil) and extreme weather events (droughts or floods) often causing severe disruption in supply chain or hampering business continuity, the issue of climate change has come to the fore.

The risk is further compounded by mitigation related regulatory policies (say due to a carbon tax or cap on fossil fuel usage or banning of diesel cars) that imposes high adjustment costs for the businesses.

Growing awareness

According to the 11th Annual EY/IIF bank risk management survey released in 2021, over 91 per cent of the chief risk officers (CRO) and 96 per cent of the board members viewed climate change as the top emerging risk in the next five years.

Climate risks in the BFSI sector can be classified into two major categories: (a) risks arising from economic costs and financial losses due to physical impacts of climate change (physical risks) and (b) risks precipitated by significant losses or cost of adjustment because of transition to a low-carbon trajectory (transition risks).

In a research report published in March 2022 by RBI titled ‘Green Transition Risks to Indian Banks’ there is a clear mention of the transition risk due to the cost of adjustment that falls in the production processes of industries that are directly or indirectly exposed to excessive use of fossil fuel.

Both these risks, arising out of climate related factors may eventually get manifested through traditional risk channels namely: (1) credit risk either due to reduced borrower’s ability to repay and service debt or bank’s inability to fully recover the loan because of default ; (2) market risk, say, due to reduction in the financial value of assets, and/or re-pricing of securities and derivatives due to stringent climate regulation; (3) liquidity risks on account of banks’ reduced access to stable source of funding because of changing market conditions; (4) operational risk due to legal and compliance risk pertaining to climate-sensitive investment; and finally (5) reputational risk due to changes in market and consumer sentiment due to changing consciousness on climate.

As traditional risk management approaches are not appropriate for measuring climate risks, regulatory authorities and businesses have opted for stress tests to assess the extent of a firms’ vulnerability to climate change.

Global experience

The frontrunners in that direction include The Netherlands, France, Banking Union in Europe, the UK, Australia, Singapore, and Canada.

In Asia, the Hong Kong Monetary Authority has also started publishing climate risk guidelines and announcing future climate stress tests. The scenario in the BFSI sector globally is also progressively transforming to align with the imperative of internalising climate risk.

For instance, De Nederlandsche Bank (DNB) established a Climate Risk Working Group in 2016 and People’s Bank of China (PBC) standardised green disclosures and green credit ratings since 2018. The Financial Stability Board (FSB) created an industry-led Task Force on Climate-related Financial Disclosures (TCFD) to bring out climate-related information that are financially material.

Climate risks also find ample recognition in the European Central Bank’s (ECB) supervisory risk assessment and in the Climate Financial Risk Forum (CFRF) established by the Prudential Regulation Authority (PRA) and the Financial Conduct Authority in UK.

In May 2021 SEBI mandated top 1,000 listed companies in India by market capitalisation to report Business Responsibility and Sustainability Report (BRSR) starting from the financial year 2022-23.

The reporting is expected to bring in greater transparency and enable market participants to identify and assess sustainability-related risks and opportunities, including climate risks. In the slew of these developments, a recent proposal by SEC (Securities and Exchange Commission) floated in March 2022 in the US on climate-related disclosure rules for public companies, which includes banks and other financial services groups, also deserves special mention.

Although the wind has started to blow in the right direction, a critical question that remains to be explored in the Indian context is whether the stakeholders in the BFSI sector, especially the banks, are ready to internalise climate risk.

A recent survey in March 2022 by Climate Risk Horizons (CRH), a think-tank, analysed 34 largest scheduled commercial banks in India by market capitalisation on the Bombay Stock Exchange (BSE) representing ₹26.81 trillion as on March 31, 2021. They inferred that only a handful of Indian banks have factored in climate risk, albeit only partially, in their business strategies.

Challenges for banks

Internalisation of climate risk factors by banks is very much on the agenda especially with RBI taking up the cudgels. However, given the complexity in climate risk modelling, the biggest challenge for a bank would be to measure the impact of climate risk while undertaking lending and investment decisions and further integrating that risk in the existing risk and valuation frameworks.

According to a recent Bloomberg survey for European banks, most banks reported that they could only confine themselves to a qualitative assessment of climate risks during the loan approval processes, which could at best be considered as subjective. The quantification of climate risk, albeit crucial, may require quality data that is not always available due to inadequate and at times inconsistent corporate disclosure.

The second challenge that a bank faces is dearth of standardised industry models to embed climate risk into enterprise risk management framework. The third critical challenge is the lack of skilled professionals who have clear understanding of both the worlds — climate risk and finance.

Das is Professor of Economics at IMT, Ghaziabad; and Bandyopadhyay is Chairperson, Centre for Business Sustainability, IIM, Lucknow

Published on July 29, 2022
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