A compendium of reports have established that climate change is one of the biggest emerging risks for banks and financial institutions. According to new research, the United States’ six largest banks - Bank of America, JPMorgan Chase, Citi, Morgan Stanley, Goldman Sachs, and Wells Fargo face above-average loan risk related to climate change. Other experts believe that climate change threatens to impact US banks more than what they are willing to disclose.
Steven M. Rothstein Managing Director, Ceres Accelerator for Sustainable Capital Market and Dan Saccardi, Program Director of the Ceres Company Network in their op-ed stated on this matter: “When considering this more complete view of climate risk, this exposure is so significant that it could trigger a financial crisis, with more than half the syndicated lending of all major U.S. banks being exposed to significant climate risk, which could translate into more than $100 billion in losses. What’s more, that figure only reflects a portion of their balance sheet, and assesses only one type of climate risk. If the full balance sheet were publicly available, the potential losses would likely be even greater.
This challenge is not just limited to the United States but extends to banks worldwide as the worsening climate change crisis continues to wreak havoc across countries.
The two major financial risks from climate change are physical and transition risks.
Physical risks: Physical risks for banks refer to the impact climate change has on a bank's operations and the wider economy. For example, extreme weather conditions triggered by climate change can result in a branch closing up, employees unable to go to work if wildfires are ablaze in their city, or customers defaulting because their house has become inhabitable due to climate disasters. A report by Ceres, which analysed $2.2 trillion of exposure for syndicated loans, revealed that "the annual value-at-risk from physical climate impacts on just the syndicated loan portfolios of major U.S. banks could approach 10 per cent, and that two-thirds of banks' physical risk comes from the indirect economic impacts of climate change, such as supply chain disruptions and lower productivity, with coastal flooding (driven by sea level rise and stronger storms) representing the largest source of direct risk".
Transition risks include the risks emerging as a bank's products and services shift to limit the global rise in temperature and move towards a low-carbon economy. This is a massive risk, and it is estimated that lending associated with fossil fuels and energy transition could result in over $100 billion in losses for U.S. banks and systemic financial risks alone.
To read more about climate risks, tools and approaches to manage them, read our blog here.
Transition to systemic risk
Experts have warned that the building up of physical and transition risks could also cascade into systemic risk to financial systems. The systemic risk here refers to the risks that could lead to the breakdown of the financial system as a whole rather than just an individual part. This has emerged as a pressing concern, with 72 private and public sector leaders having penned letters to the heads of financial regulatory agencies, urging them to regulate climate change as a systemic financial risk.
The impact of climate change and its glaring risks has compelled regulators to explore appropriate responses to them. These efforts are already underway as banking authorities, and risk managers globally are launching initiatives to assess how climate risks are being managed, ensure resilience and introduce efforts required to address these risks effectively. Some of the notable responses by major banking regulators are encapsulated below:
The Federal Reserve Board (Fed)
In September 2022, United States’ central banking system announced that 6 of the largest banks in the country would participate in a pilot climate scenario analysis exercise. Expected to launch in early 2023, the exercise is designed to “enhance the ability of supervisors and firms to measure and manage climate-related financial risks”. Scenario analysis is undertaken to gauge the resilience of financial institutions under different probable climate scenarios and financial variables, among other factors. The board’s review of the firm analysis will help them ramp up capacity-building efforts to address climate-related financial risks effectively. This exercise is expected to establish climate scenario analysis as a key tool in bank risk management frameworks.
The Securities and Exchange Commission (SEC)
SEC, an independent agency of the United States federal government, on March 21, 2022, proposed rules to enhance and standardise climate-related disclosures for investors. This effort is hailed for helping bring in reliable information that can drive informed investment decisions. The rule changes would require registrants to attach climate-related disclosures in their registration statements and periodic reports. This would entail disclosures of their GHG emissions and any other information regarding climate-related risks which could have a material impact on their business and operations. According to SEC Chair Gary Gensler “if adopted, it would provide investors with consistent, comparable, and decision-useful information for making their investment decisions, and it would provide consistent and clear reporting obligations for issuers.”
Bank of England (BoE)
United Kingdom’s central bank has made a 10-part pledge to take forward their climate agenda across their strategic priorities. Towards this end, some of their notable efforts include advocating for climate disclosures and developing climate scenarios. In 2021 the BoE conducted its first comprehensive stress test to assess the capability of the British financial system to deal with the impact of climate change. The test analyzed the resilience of the country’s 19 biggest banks and insurers to the impact of extreme climatic events and the shift to a net zero carbon economy in the coming years. The test was based on three scenarios in relation to climate action, spanning 3 decades and incorporated physical and transition risks.
The European Central Bank (ECB)
The ECB, which is the prime component of the Eurosystem and the European System of Central Banks, conducted the 2022 climate risk stress test this year as a part of their larger efforts to analyse "supervised institutions' level of preparedness for properly managing climate risk". The stress test is designed to help understand the internally built resilience of banks in scope. The exercise is also helpful in assessing the progress made by banks in developing stress-testing frameworks, their capacity to produce climate risk factors and climate risk stress test projections, among other capabilities. In addition, the ECB is undertaking a supervisory thematic review of banks' climate-related and environmental risk management practices. This exercise will help them analyse how banks have embedded climate risks in their strategies and risk management approach. The thematic review and climate risk stress test will help understand which banks align with the ECB's supervisory expectations. These exercises are vital in understanding climate risks and the entity's capabilities to respond to them. For example, an ECB report stated "although some progress has been made since 2020, the European Central Bank (ECB) 2022 climate risk stress test results show that banks do not yet sufficiently incorporate climate risk into their stress-testing frameworks and internal models."
The Reserve Bank of India (RBI)
In an attempt to make India’s financial system resilient to climate-related risks, India’s central bank has started to undertake initiatives towards that end. In July 2022, for example, the RBI released a Discussion Paper on Climate Risk and Sustainable Finance. It has invited comments on the paper from regulated entities and other stakeholders. The RBI also undertook a survey on Climate Risk and Sustainable Finance earlier this year. The survey included 12 public sector banks, 16 private sector banks and six foreign banks in India. It was undertaken with the objective of analysing the level of preparedness in managing climate risks by the top scheduled commercial banks. The results of the survey, which have been published, are being assessed to derive essential insights that can help shape the RBI's regulatory and supervisory approach to climate risk and sustainable finance.
The Monetary Authority of Singapore (MAS)
On October 2022, MAS announced the establishment of a Sustainable Finance Advisory Panel (SFAP). Set up to guide MAS regarding its strategies towards building a sustainable finance ecosystem, the SFAP comprises a diverse group of senior sustainability experts. MAS also undertook the 2022 Industry-Wide Stress Test exercise. In addition to these efforts, it also publishes information papers on environmental risk management practices of banks, insurers and asset managers. The Central Bank is also expected to reduce the emissions intensity of its equities investments by up to 50% by the financial year 2030 in order to meet its objective of a climate-resilient reserves portfolio.
The Importance of Data
Amidst the major efforts being taken, Chief Risk Officers have identified major challenges in addressing climate risks, such as the lack of agreed industry methodologies and external dependencies, among others. However, data asymmetry has been one of the major challenges in effective climate risk analysis.
Credible and high-quality data is essential for better risk analyses and buttress decision-making processes. Accurate, credible data is the cornerstone of a reliable climate model. While many factors play an important role in bettering climate models, such as strong computing systems capable of crunching more data and effective frameworks, data remains the paramount factor for effective climate modelling. This is because a climate model is only as good as its inputs. It not only increases the accuracy of the models but also helps in creating better simulations. This further helps provide a clear picture of risks and, thus, by extension, aids in building resilience against them. The accuracy of several risk management tools discussed above, can predict the manifestation of risks over different time horizons and economic factors, to a large extent, depending on the inputs. In addition, credible data is also imperative for compiling ESG disclosures. Considered an “important tool(s) for the banking sector to better guard against climate risks in the short and medium term”, data plays an important role in ensuring enhanced disclosures.
Rapid development of technology, however, is increasingly helpful in gathering climate intelligence and capturing the financial impact of climate change. Satellite data, specifically, plays an important role in monitoring climate change and makes up for the shortcomings of traditional monitoring tools such as IoT monitors and forest guards, which are expensive and time-consuming and have emerged as effective tools in ESG reporting. Large-scale climate datasets aggregated from satellites and sensors can also provide data at a granular level. This, along with sophisticated processing systems and analytical skills, has revolutionised climate intelligence.
The possible consequences of inaction are dire, risking the collapse of the entire financial system. While an upward trend is noticed with regard to recognising climate risks in the banking sector, more progress, however is needed, especially when it comes to a firm's risk management and scenario analysis capabilities. The role of data here is imperative, as losses could be minimised to a great extent if stakeholders are able to identify climate risks effectively. A concerted, systemic and collective action by regulators worldwide to recognise and respond to climate risk are essential to spur an orderly transition to a low-carbon economy.