Climate change risk & bank sustainability

The central role of the banking sector is to provide financial services to achieve developmental targets. But the climate change risk has made it imperative for banks to take up sustainable finance. Climate-related risks manifest in frequent and destructive weather patterns causing significant losses to the public, corporates, banks and insurance companies and pose a serious threat to financial stability.

Accordingly, it is necessary to adjust and allocate resources effectively. Banks need to respond quickly in recalibrating business models, rating assessment tools for driving profitable growth in the long run. Banks need to know which are the assets that will continue to benefit the environment. Calamity risk is important for managing credit risk in agricultural loans.

Moreover, an increase in food inflation may push the interest rate up triggering commodity price risks. Such global negative externalities require a coordinated approach at both local and global level to effectively deal with the situations.

Nature of climate change risk

Climate change risk is described as an uncertainty caused by severe weather events such as floods, droughts and typhoons causing disasters that bring physical risks with negative impact on business and the overall economy.

The cost of catastrophic weather events are rising in terms of loss of lives and livelihoods, savings, capital assets, jobs and incomes. This may lead to transition risks (in terms of change in the mode of operations, systems and processes, relocation, etc.) which may further raise operating costs.

Climate risk event is defined as “a green swan” that is outside the normal range of expected events (BCBS 2020). Covid-19 may be considered “a black swan” (the concept popularised by Nassim Nicholas Taleb) event because it happens once in 100 years (tail risks, non-normal). There is also limited precedent for how a global pandemic will impact the financial markets. Green swan events are different from black swan events since there is some certainty over climate change risks materialising one day (highly likely of occurrence but uncertain timing of occurrence).

Assessment approaches

Climate change risk has the capability of wreaking havoc on nations and industries. It can destroy lives and livelihoods and severely damage the financial system. The Covid-19 pandemic situation has shown how climate change can cause risk to financial stability.

Despite the best efforts by the central banks and governments to underpin the financial system to get through Covid-19, it has clearly demonstrated the importance of sustainability issues. Since March 2020, it has adversely impacted the global economy from international finance and supply chains and caused large scale unemployment and corporate distress.

Many established banks reported losses in Q4FY20 due to stress and uncertainty in the Indian banking system caused by the pandemic. This was following higher provisions for bad loans due to the prevailing pandemic situation. Data capturing, building tools and knowledge to improve and recalibrate risk modelling and stress testing have become crucial.

This is why the Bank of England is going to carry out climate stress tests for financial service firms in June. The aim is to test different combinations of physical and transition risks over a 30-year period. In order to raise investors’ ecological awareness, the United Kingdom has introduced a “green taxonomy” to label assets.

The wildfires in Australia and California, record level temperature changes in various zones (in the Arctic Circle, for instance), and pandemic outbreaks are a striking reminder of the need for sustained action by government, regulators, public as well as private authorities.

Banks need to factor in how climate risk can impact their business and examine whether additional capital needs to be held against such risks. Capital assessment exercise requires good data, key risk indicators (KRIs) and process to be set up.

A recent study has shown that there is a significant negative relationship between distance to default of companies and CO2 emissions and carbon intensity. This means, companies with high carbon emissions and intensity are perceived by the market as more likely to default.

Similarly, debtors receiving huge environmental fines from authorities for waste pollution, plastic and car producers losing significant amounts of business due to new legislation, loans not being repaid due to crop failure and business closures due to pandemic situation are a broad range of scenarios that capture the cost of climate change risks.

Banks need to factor these types of causal relationships in their credit rating models. Similarly, a greater volatility in commodity prices may lead to higher market risk in bank’s investment portfolio.

Management of climate risk

Banks must assess the impact of climate change risk and integrate it in the areas of governance, risk management, scenario analysis and disclosures and examine their readiness for recent and upcoming climate related supervisory expectations.

Development of efficient assessment methods to internalise climate change scenarios and understand their impact on capital and business is critical to effectively reduce their risks. Globally best practiced banks have started conducting portfolio stress tests to assess the effect of increasing climate risk events on their loan portfolios (Agriculture, Housing, Commercial, Project Finance etc.).

Climate change risks can cause potentially large negative shocks in banks’ trading portfolio as well. Banks need to include asset price stress scenarios into their statistical Value at Risk (VaR) and Expected Shortfall (ES) models to examine their impact in terms of additional capital and profit.

This will enable banks to proactively deal with the climate change threats.

The writer is Associate Professor and Dean Education, National Institute of Bank Management. Views expressed are personal

COMMENT NOW