Climate resilience in banking: Incorporating physical and transition risks

Climate resilience in banking has become a critical concern as financial institutions grapple with the dual challenges of physical and transition risks posed by climate change. These risks have significant implications for banks’ operations, asset valuations, and overall financial stability.

Physical risks stem from extreme weather events and long-term climate shifts and can damage assets, disrupt operations, and increase credit defaults. For instance, a World Bank study in the Philippines from 2011 to 2018 found that a 1% increase in typhoon damage ratio led to an increase in non-performing loan (NPL) ratios by as much as 2.3% in the banking sector. Transition risks, on the other hand, arise from policy changes, technological advancements, and market shifts as economies move towards low-carbon models. These can potentially devalue carbon-intensive assets and alter business landscapes. Banks with significant exposure to fossil fuel industries or carbon-intensive sectors may face increased credit risks as these industries become less viable in a low-carbon economy.

The Indian context

India’s vulnerability to climate change is particularly acute. Recent data underscores the severity of the situation with India accounting for a quarter of Asia-Pacific’s US $230 billion economic loss due to weather-related disasters in 2023.This staggering figure highlights the urgent need for the Indian banking sector to incorporate climate resilience strategies. Recognising the criticality of climate-related financial risks, the Reserve Bank of India (RBI) has taken initial steps to address them through its Draft Disclosure framework on Climate-Related Financial Risks in February 2024. Although such regulations exist, integrating climate risks into core banking functions such as Enterprise Risk Management (ERM), Internal Capital Adequacy Assessment Process (ICAAP), and credit appraisal is still in its early stages.

Gaps and issues

Despite growing awareness, several challenges hinder the effective incorporation of climate risks into internal banking processes:

Data availability and quality: Reliable and granular climate-related data, especially at the level required for risk assessment, remains scarce. Banks struggle to obtain comprehensive data on their clients’ emissions and climate vulnerabilities, particularly for small and medium-sized enterprises. The lack of historical data on climate-related events and their financial impacts also poses a challenge for accurate risk modelling
Methodology and standards: There is a lack of standardised methodologies and frameworks for assessing climate risks, making it difficult to compare and benchmark performance. The complexity of climate risk drivers and their effects on banks’ financial risks further complicates the development of consistent approaches
Capacity building: Many banks lack the necessary expertise and resources to assess, manage, and disclose climate-related risks effectively. This includes a shortage of skilled professionals with both climate science and financial risk management expertise
Regulatory clarity: While some central banks have issued guidelines, more specific regulations and supervisory expectations are needed for effective implementation. The lack of explicit mandates regarding climate-related financial risks in many jurisdictions creates uncertainty for banks
Long-term perspective: Climate risks often have long-term horizons, making it challenging to align them with short-term financial performance metrics. Banks struggle to incorporate long-term climate scenarios into their traditional risk management frameworks, which typically focus on shorter time horizons
Integration challenges: Banks face difficulties in integrating climate risk considerations across all relevant business units and functions. This includes challenges in incorporating climate risks into existing credit risk management processes and portfolio strategies.

Best Practices

Despite these challenges, few practices exist which are being used by banks globally to tackle these challenges whilst building climate resilience:

Scenario analysis: Conduct climate scenario analysis to assess the potential impact of different climate change scenarios on the bank’s portfolio and business model. This should include both physical and transition risks, using a range of scenarios that cover various temperature outcomes and policy pathways
Risk identification and assessment: Identify and assess climate-related risks, including physical risks transition. Develop comprehensive risk taxonomies and integrate climate risk factors into existing risk assessment frameworks
Data management: Invest in data infrastructure to collect, manage, and analyse climate-related data. This includes developing partnerships with external data providers, leveraging new technologies for data collection and analysis, and improving internal data sharing processes
Climate risk integration: Incorporate climate risks into existing risk management frameworks, such as ERM, ICAAP, and credit appraisal
Disclosure: Enhance climate-related disclosures to provide transparency to stakeholders. Align disclosures with established frameworks such as the Task Force on Climate-related Financial Disclosures (TCFD) recommendations
Stakeholder engagement: Engage with clients, investors, and regulators to build a shared understanding of climate risks

The Indian banking sector is still in the early stages of climate risk management, though some banks, like ICICI Bank and HDFC Bank, have made notable progress.

ICICI Bank (India) has developed a comprehensive climate risk management framework, including borrower-specific climate risk scores, integration of climate risk assessments into credit processes, and sector-specific policies for carbon-intensive industries. They are also focusing on financing renewable energy and infrastructure projects and measuring their carbon footprint, including assessing Scope 3 emissions in areas such as business travel and purchased goods. ICICI Bank has also developed sector-specific checklists to assess ESG and climate-related physical and transition risks in industries like transportation, cement, and steel.

HDFC Bank has taken several steps to address climate risks like enhancement of its ESG risk management policy, integration of ESG and climate change risks into credit assessments, engagement with corporate borrowers on their transition plans, and alignment with reporting frameworks like TCFD and GRI Standards.

Globally, multiple banks in different geographies have taken significant strides in integrating climate risks in their processes. As Australia’s largest agribusiness bank, the National Australia Bank (NAB) stance towards addressing climate risks include:

Conducting extensive stress testing and back book analysis to understand climate impacts across various sectors
Developing tools to help customers manage and mitigate climate-related risks
Identifying opportunities for adaptation and building resilience in the agricultural sector
Incorporating climate risk considerations into lending decisions and portfolio management

TD Bank Group (Canada) has focused on leveraging technology to assess climate-related risks and opportunities and has:

Collaborated with Bloomberg MAPs to use data visualisation tools for climate risk assessment
Integrated climate risk analysis into their stress testing processes
Developed strategies to support the transition to a low-carbon economy
Enhanced disclosure of climate-related risks and opportunities in line with TCFD recommendations

To strengthen climate resilience, India’s banking sector needs clearer regulatory guidance from the RBI. Although the draft disclosure mentions scenario analysis and stress testing and working paper on “Climate Risk and Sustainable Finance” provides a foundational framework, more details on how to integrate climate risks is required. Furthermore, standardised climate risk assessment methodologies, capacity building in climate risk expertise, and greater data sharing and collaboration among stakeholders is also paramount. Additionally, incentivising banks to finance low-carbon projects will be essential. By proactively managing climate risks, banks can protect their financial stability and contribute to a sustainable future. Given the growing frequency of climate-related events, swift action is crucial for financial resilience.

References

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