Five Critical Factors for Banks’ Climate Risk Management

By Richard Bennett, CEO, Razor Risk

Introduction

It is widely recognized that continued emission of greenhouse gases will cause further warming of the Earth.

Indeed, a rise in temperature above 2° Centigrade (2°C), relative to the pre-industrial period, could lead to catastrophic economic and social consequences for the globe. Such is the threat that in December 2015, nearly 200 governments agreed to strengthen the global response to the threat of climate change by “holding the increase in the global average temperature to well below 2°C above pre-industrial levels and pursuing efforts to limit the temperature increase to 1.5°C above pre-industrial levels”, referred to as the Paris Agreement.

This is just one example of multiple pieces of national and international legislation, all carried out against a backdrop of a much more environmentally aware audience, that is placing pressure on all powerful organisations to “do their bit” when it comes to protecting the environment. Banks – as one of the most powerful global organisations – therefore have a huge role to play. Just as they are the leaders in global finance, they have the perfect opportunity to carve out a role as a leader in global ESG matters.

However, their efforts to increase their green credentials must be done against two important factors. On the one hand, they need to manage their own financial exposures, while on the other they must finance the climate change that will be critical to mitigate the impact of global warming.

An imperative in both cases is agile and considered climate risk management.

The regulatory backdrop

It is important to note that regulation is increasingly becoming an unavoidable feature that banks must adhere to for the good of managing climate risk. However, while some banks have made a promising start, many must still formulate strategies, build their capabilities, and create risk-management frameworks.

The imperative now is to act decisively and with conviction, so effective climate risk management will be an essential skill set in the years ahead. Banking regulators around the world, now formalising new rules for climate- risk management, intend to roll out demanding stress tests in the months ahead. Many investors, responding to their clients’ shifting attitudes, already consider environmental, sustainability, and governance (ESG) factors in their investment decisions and are channelling funds to “green” companies.

The commercial backdrop

The commercial imperatives for better climate risk management are also increasing. In a competitive environment in which banks are often judged on their green credentials, it makes sense to develop sustainable-finance offerings and to incorporate climate factors into capital allocations, loan approvals, portfolio monitoring, and reporting.

Some banks have already made significant strategic decisions, ramping up sustainable finance, offering discounts for green lending, and mobilising new capital for environmental initiatives.

The key factors for climate risk management

As they seek to become effective managers of climate risk, banks need to quantify climate factors across the business and put in place the tools and processes needed to take advantage of them effectively.

At the same time, they must ensure that their operations are aligned with the demands of external stakeholders. Five critical factors will support this transformation. They should be applied flexibly as the regulatory landscape changes.

1.Governance – Climate risk. It will be of crucial importance for top management to set the tone on climate risk governance. Banks should nominate a leader responsible for climate risk; chief risk officers (CROs) are often preferred candidates. To ensure that the board can keep an eye on exposures and respond swiftly, banks should institute comprehensive internal-reporting workflows. There is also a cultural imperative: responsibility for climate risk management must be cascaded throughout the organization.

2.Modify business and credit strategy. Climate considerations should be deeply embedded in risk frameworks and capital-allocation processes. Many Banks have decided not to serve certain companies or sectors or have imposed emissions thresholds for financing in some sectors. Boards should regularly identify potential threats to strategic plans and business models.

3.Align risk processes. To align climate risk exposure with risk appetite and the business and credit strategy, risk managers should inject climate risk considerations into all risk-management processes, including capital allocations, loan approvals, portfolio monitoring, and reporting. Some Banks have started to develop methodologies for assessing climate risk at the level of individual counterparties.

4.Undertake Scenario Analysis and Stress Testing. Scenario analyses and stress tests, which are high on business and regulatory agendas, will be critical levers in helping banks assess their resilience. In preparing for tests, they should first identify important climate hazards and primary risk drivers by industry, an analysis they can use to generate physical and transition-risk scenarios. These in turn can help banks estimate the extent of the damage caused by events such as droughts, floods, and heat waves. Finally, banks must quantify the impact by counterparty and in aggregate on a portfolio basis. Risk-management teams should also prepare a range of potential mitigants and put in place systems to translate test results into an overview of the bank’s position. Since regulators are prioritising stress testing for the coming period, acquiring the necessary climate-modeling expertise and climate- hazard and asset-level data is an urgent task.

5.Invest in technology, data, and people. Banks often lack the technical skills required to manage climate risk. They will need to focus on acquiring them and on developing a strategic understanding of how physical and transition risks may affect their activities in certain locations or industry sectors. Banks usually need “quants,” for example—the experts required to build climate-focused counterparty- or portfolio-level models. They should therefore budget for increased investment in technology, data, and talent.

Conclusion

The ability to have a watertight ESG risk-profile is no longer a nice-to-have for the banking sector, it is a must-have.

However, banks are not – and cannot be expected to be – experts in ESG matters. Their day-job always has always been to make money and protect the financial interests of their clients. To ensure the sector remains healthy, especially in the face of an ever-changing geo-political landscape, this must remain unchanged.

However, they have a central role to play in all things to do with climate risk management, this cannot be ignored. This is something that will be welcomed by multiple generations, starting with those of us in the present, to our ancestors, way into the future.