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How Climate Risk could proliferate other Secondary risk types

How Climate Risk could proliferate other Secondary risk types 3

By Manoj Reddy, Head of BFS Risk and Compliance Practice for TCS North America

The gamut of enterprise risk management has been expanding over the last two decades and the last decade which has witnessed the after effects of a brutal financial crisis and tectonic shifts in business models, customer management and accelerated digital adoption has only meant that newer risk types have been identified as material risk owning to the threat they pose to business stability and soundness or the amount of losses directly attributable to them.  Though credit, market and operational risk, still drive the computation of regulatory capital, the economic capital and ICAAP processes have seen quantification models for secondary risk types and some of these models are getting more quantitatively intensive beyond their primitive forms of qualitative approximations.  Climate risk is the latest entrant into enterprise risk management space and is one of the more potent risk types which has been garnering a lot of attention and for good reason as climate change is dominating discussion and views in global economics, political, social and financial circles. 

Impact of Climate Risk on Secondary Risk types 

What makes climate risk so prominent and visible is its two-dimensional impact from a physical risk (direct impact of climate changes) and transition risk (indirect impact of moving from existing infrastructure to a greener one).  To further add to the intricacies of the direct and indirect impacts of climate change, is the overwhelming possibility of the cross impact of climate risk on established primary risk types and secondary risk types from a holistic perspective of enterprise risk management.  Climate change events are likely to significantly impact the secondary risk types as well beyond, warranting the need to create or enhance dedicated framework to identify, assess, control and monitor them.  Below is a representation of some of the secondary risk types which are very likely to be impacted by Climate risk.

How Climate Risk could proliferate other Secondary risk types 4

Secondary Risk types which are most likely to be Impacted  

1.Business & Strategic Risk –   Strategic risk is the negative impact to the business on account of poorly designed and implemented strategies.  In the context of climate change, lending policies promoting green financing, new product and service launches for green projects and Investment in green bonds could all be representative of Industry aligned business strategy.  Business strategies which are misaligned could result in increased direct financial losses, higher number of defaults, alleviated public perception, etc.,  Though most of these would end up being viewed as credit or operational risk, it is important to understand that the root cause for these could be emanating out of a misaligned business strategy and hence should ideally be attributed as a strategic risk.   There needs to be adequate consideration given the right product, marketing, location, customer management and public relations strategy to ensure it is well aligned to the Industry direction on Climate change.   Most Banks today might have a qualitative or judgement based approximation for strategic risk,  which is likely to be challenged with time as greater number of losses could be attributed to the incorrect strategies immune to climate change designed and Implemented necessitating the need for a more robust strategic risk management framework.

Manoj Reddy

Manoj Reddy

2.Political and Legal Risk –  The pace of transformation towards green initiatives in a given region or geography will be largely determined by the policies and a conducive business, social and economic environment established by the corresponding government and regulatory authorities.  Though Political risk is considered in Business and strategic planning, very few banks have a quantification methodology or a framework in place to manage political risk.  Legal risk on the other hand, also called compliance risk is largely managed through compliance management function within banks and similar to political risk it may not have a quantification model of its own.   Transition to a greener initiative driven by climate change events will be championed and mandated by government and regulatory authorities, thus driving the need for banks to manage political and legal risk in a much more focused and methodical manner. 

3.Model Risk – One of the key challenges for Banks in their efforts to manage the impacts of climate change will be their ability to incorporate the vast amount of Industry data into their internal predictive models.  There have been several advancements in Model risk management due to regulatory focus and feedback and most banks today have a robust Model risk management function.  However, given that a lot more of the business outcomes are going to be impacted by climate change events, we are likely to witness deviation in model predictions for those models which have not be calibrated to include the climate change variables, thus raising the alarm bells on incorrect or inadequate modeling thus further elevating the focus on Model risk management. 

4.Conduct Risk – Conduct risk is in its nascent stages in the Industry with most Banks likely to have a foundational framework in place.  Funding green initiatives are not expected to be very profitable to Banks in the immediate term as the Industry will jointly tread the path to a greener planet.  Hence, it will be a huge challenge for banks to balance strategic long-term sustainability with immediate short-term profitability.  Instances, where Banks demonstrate a questionable conduct by way of  charging a premium interest rate to finance green initiatives or create disincentives to its customers by way of charging hidden fees, lower returns or inadequate information could be considered as conduct risk events.  Climate change reforms are likely to put the perceived conduct by banks under sharper focus and it is here that a strong conduct risk framework will be invaluable for bank to steer clear of potential conduct risk events. 

5.Reputational Risk – Reputational risk is defined as financial loss that can be attributed to a compromised reputation. Climate change reforms will require the Finance Industry and especially Banks to come together to make a material change and propel the transition to a greener economy.  Thus, increasing the pressure of perception on banks to appear as championing and supporting the green initiatives and safeguarding their reputation as a responsible stakeholder in this colossal transition.    Bank’s might need to go beyond the existing qualitative approach to managing reputation risk to designing a palpable framework which can help identify, assess, mitigate and monitor reputation risk specially in the light of climate change reforms. 

6.Third party Risk –   Third party risk management is being carved out of operational risk management in the recent years.  Banks depend on third party entities for Industry data, operational and Information technology software and services and Infrastructure management.  Given that climate change is gong to drastically impact all Industries and entities across industries, Banks will need to pay closer attention to their third party risk management framework and specially identify their vulnerabilities and dependencies in third parties which will impact their sustenance and Business continuity.   

Conclusion

Though, Climate risk is going to one of the most compelling risk types that will be added into the enterprise risk management domain as a material risk type, it has the potential to proliferate other secondary risk types and push them in the forefront of enterprise risk management as well.  None of the secondary risk types identified above are new to the financial industry, it is just that they have been on the sidelines and are likely to get accentuated by climate change events.  There is already an encouraging amount of awareness and anticipation around the obvious impact on the primary risk types, but Banks that can identify, understand and analyze the impact to their secondary risk types ahead of the curve are likely to transition with fewer pitfalls in their journey towards a greener planet.  

About Author:

Manoj Reddy is the Head of BFS Risk & Compliance Practice for TCS North America with an experience of more than 18 years in the areas of financial services, IT, and business consulting. Reddy has led several risk & regulatory consulting and implementation engagements for financial firms globally. He has provided both Regulatory and Strategic Business solution to his customers over the last decade primarily in the area of CCAR, Basel, Liquidity Risk and Enterprise Risk management and is currently leading TCS efforts in North America with respect to providing Business & technology solutions to BFSI customers in the area of Risk, Regulatory & Compliance transformation and advisory services in Industry reforms and Climate change.

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