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Challenges banks face when it comes to climate change risk

06:00 PM Oct 26, 2021 | Ashish Nayyar

In addressing climate change, bank boards are being pushed by all stakeholders (the regulators, investors, customers, the general public, the media, etc.) to establish a strategic view and risk appetite which accommodate and reconcile both the risks and opportunities arising from climate change and the transition to a greener economy.

Investors and regulators expect governance structures and banks’ culture to support risk management and be effective in cascading the climate change strategy and risk appetite throughout the firm.

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There are however, numerous challenges in addressing this:

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Data + Granularity

Many banks may already have a lot of the data they need to assess climate risks in their portfolios, but they may not have it captured and aggregated in a way that makes it easy to analyze, or have the level of granularity needed to make an assessment. In order to evaluate physical climate risks, banks need to have data around things such as:

o What are the borrowers’ physical assets? Where are they located?

o How do they operate?

o Where do they source their supply?

o Where do they sell products?

o Has their local area experienced climate change events in the past? If so, how often and how recently?

o What was the local emergency response like? As depending on how effective it is, this can have a significant impact on the level of damage done.

When it comes to transition risks, banks may look at data such as:

o What is the demand for electric vehicles and how has it changed in recent years?

o What about vegan and vegetarian menus and restaurants?

o How do they operate?

o How would this business be impacted by a carbon tax?

Predicting future risks

Climate risks are highly uncertain and non-linear in their propagation and can affect multiple risk categories simultaneously. Historical loss experience cannot therefore be used to estimate the future risks. The materiality of climate change will differ from bank to bank depending on the types of risk they’re taking on, the duration of risk they’re taking on, where they’re based, etc. A bank based on the Gulf Coast or West Coast of the US for example, or with a large portion of its loan book focused there, is likely to be more immediately concerned with the physical risk. Whereas, for banks based in other regions with few clients in physically vulnerable locations, the priority is likely to be on transition risk.

Balancing very long-term horizons with immediate risks

While many of the goals set with regards to climate change are focused on a long-time horizon, there are immediate risks. Transition risks are already impacting borrower business models, and we’ve seen the physical risks given the numerous climate change events reported. This requires an extension of traditional bank strategic planning horizons beyond the typical three to five years. If you consider the Paris Accords for example, we’re talking about a goal for 2050, so it’s a very long-term goal and banks aren’t used to working in these timelines.

Consistency of messaging

Across all aspects of climate and to all stakeholders. Banks need a unified approach with a consistent framework to communication with their Board, the regulators, shareholders, their customers, etc.

Expertise

Climate change is a new area for all of us, so there's a huge education process that needs to take place across organisations – from loan originators and risk managers to entry-level employees and the Board – to create climate confident bankers.

Proportionality

There is uncertainty about the appropriate governance structures required for different sized firms, and the level of detail needed to meet disclosure standards effectively.

Given all the challenges and opportunities outlined earlier, it is clear that collaboration will be key. The more that banks can share experiences, data and methodologies around climate change with one another, the easier it’s going to be for the industry to create some consistency around measuring it, and the better prepared we will all be to support our customers.

(Ashish Nayyar is Co-Head of India, OakNorth-UK bank for small and medium-sized companies)

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