Climate challenges are emerging in their scope and scale, and they negatively impact various aspects of financial systems, from investors to institutions.
This write-up will dive into the interrelatedness between climate change and banking.
Banks are heavily exposed to numerous and complex risks every day. These risks can be identified as credit risk, market risk, strategic risk, ALM risk, liquidity risk, funding risk, reputational risk, and legal risk.
On top of these daily risks, central banks are now considering climate risk as a fundamental concern particularly in achieving the objectives of the Paris Agreement.
Climate risk for financial institutions is categorised into Physical Risk and Transition Risk. Physical Risk is defined as extreme weather events and long-term shifts in climate that threaten financial firms. On the other hand, Transition Risks are those that result from changing policies, practices, and technologies as organizations shift toward a low-carbon economy.
Physical risk can lead to the closure of retail branches or facilities, which will adversely affect asset prices, and negatively impact the creditworthiness of clients.
To elaborate on the abovementioned, climate risks can hit banks in the following areas:
Operational Stability – Natural disasters like typhoons and floods directly disrupt banking operations through the loss of lives and the destruction of premises.
Damage to a bank’s branch network will decrease the bank’s financial health as customers will not be able to transact with the branch where their accounts are managed. Damage to a bank’s headquarters will decline the bank’s managerial capacity to process loan applications and investments at the back office.
As a result, the overall operating income of the bank will adversely be affected.
Financial Performance – When banks suffer physical or capital damage as a result of extreme weather events, they may not be able to provide sufficient funds and products at the same interest rates as before.
Due to such financial constraints, firms may not be able to finance capital investment or the fixed costs associated with entering a foreign market (e.g., the costs of building a sales network abroad and adapting products to local tastes and regulations).
Financial constraints may also restrict the volume of exports (i.e., the intensive margin of exports) of firms that have already started exporting due to a reduction in the amount of trade finance.
Creditworthiness – In a climate stress test conducted by the Bank of England, the result indicated that banks could incur up to £225bn in credit losses by 2050. Climate-related risks affect all three dimensions of credit risk – a borrower’s capacity to generate enough income to service and repay its debt as well as the capital and collateral that back the loan. For banks, credit risks can directly materialise through exposures to corporations (ie., bonds and stocks), households (ie., mortgages, assets, and loans), and countries that experience climate shocks (ie., government securities). While the indirect outcome will be felt through the effect of climate change on the wider spectrum of the economy and feedback effects within the financial system. Credit exposures manifest through an increased default risk of loans, portfolios, or lower values of assets.
An increase in extreme and severe weather events could have second-round effects on the price of corporate bonds, and the rise in debt defaults would induce climate-related financial instability which would adversely affect credit expansion and magnify the negative impact of climate change on financial activity.
Contact us here and find out more on how CLIMATIG can help you navigate these risks.