Climate change has achieved the status of one of the most compelling topics of discussion in political, economic and social circles, given its multidimensional threat to the long-term sustainability of our planet. This risk posed by climate change is now seriously viewed as a significant risk for banks and financial services companies – in some cases this risk has already resulted in attributable financial losses.
While the magnitude of the impact on each financial institution may vary, it is increasingly clear that nearly all financial services companies are going to be directly or indirectly affected by customer failures, their investments in assets and titles sensitive to climate, or simply by their exposure. as a business entity.
Therefore, it is imperative that banks understand the impact of climate risk on the entire credit risk value chain – from identification and assessment, to mitigation and monitoring.
Credit risk policy increases: Credit risk policy should reflect an approach to mitigate the impact of physical and transitional risks of climate change on existing and potential borrowers. These policies are not recommended to be immediately punitive, but they should gradually discourage borrowers whose climate risk profile does not improve. Likewise, credit policies could be favorably changed with higher risk tolerance and credit limits to encourage lending to greener assets.
Rating and rating of climate risk: One of the main challenges in mitigating the direct or indirect risks of climate change is the lack of quantification models and methodologies that can inform an appropriate credit response. Although climate risk rating is still in its infancy, financial services firms will need to adopt a fundamental framework for rating or rating climate risk, or at the very least use it as an input into borrower rating dashboards.
Early warning framework: Filtering out negative customer news is part of an early warning framework at most banks. These frameworks could be enhanced to capture climate risk events related to their customers or highly exposed industries. This can help loan officers assess the potential threat. For example, negative news about the impact of climate change on coastal properties linked to a real estate builder borrowing from the bank should be addressed by the early warning framework, even if it is not about ‘direct news of financial losses, downgrading or bankruptcy.
Credit risk modeling: Credit risk models such as probability of default (PD) and loss given default (LGD) should be calibrated to include climate change risk factors taking into account their correlation with defaults or anticipated defaults . Securities or assets linked to climate-sensitive companies or guarantors with high credit risk profiles should be considered in LGD models. While the lack of observed historical data is a huge challenge when working to draw solid inferences, simulation models with anticipated impact can help account for the impact on credit risk models.
Stress tests and capital management: Stress test scenarios, both from a portfolio perspective and from a regulatory capital management perspective, must take into account the impacts of climate change. Ideally, these scenarios should be designed to assess the impact of default by large individual borrowers, as well as the impact on the portfolio due to the macroeconomic effects of climate change on specific sectors or geographic areas. Calibration of the PD and LGD models would facilitate provisioning for credit losses and calculations of economic capital.
Credit risk reports and dashboards: Climate change sensitive credit risk measures need to be closely monitored and communicated to senior management and the board. Climate-sensitive exposures should ideally be labeled in recording systems, and also sliced and diced across multiple dimensions of credit risk management. Climate risk reporting should not be viewed solely from a regulatory disclosure perspective – it should be deeply embedded in key indicators of credit risk.
The impact of the climate on credit risk management is already materializing and is expected to grow exponentially. Financial services firms that take a proactive approach to assessing the impact on the balance sheet and that strive to calibrate their credit risk frameworks will be better placed to minimize their credit losses and will also play a key role as agents of change in the transition to a greener planet.