Reimagining credit risk in the context of climate risk

Climate change has attained the status of one being of the most compelling topics of discussions across political, economic and social circles, given its multi-dimensional threat to our planet’s long-term viability. This risk posed by climate change is now being seriously considered as material risk to banks and financial services firms — in some cases, that risk has already resulted in attributable financial losses.

Although the magnitude of impact on each financial institution may vary, it is increasingly clear that almost all financial services firms are going to be impacted either directly or indirectly via customer defaults, their investments in climate-sensitive assets and securities, or simply through their exposure as a business entity.

Hence, it is imperative for banks to understand the impact of climate risk across the overall risk value chain of credit risk – from identification and assessment, all the way to mitigation and monitoring.

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Credit risk policy augmentations: Credit risk policy needs to reflect an approach toward mitigating the impact of both the physical and transition risks of climate change on existing and potential borrowers. It is not recommended that these policies be instantly punitive, but they should be progressively disincentivizing for borrowers whose climate risk profile is not ameliorating.  Similarly, credit policies could be amended favorably with higher risk tolerance and credit limits to foster lending toward greener assets.

Climate risk scoring and rating: One of the principal challenges around mitigating the direct or indirect risks of climate change is the lack of quantification models and methodologies that can inform an appropriate credit response.  Though climate risk scoring is in its nascent stages, financial services firms will need to adopt a foundational framework for climate risk scoring or rating capability, or at the very least use them as an input into borrower rating scorecards.

Early warnings framework: Negative news screening of customers is part of an early-warning framework at most banks. These frameworks could be enhanced to capture climate-risk events tied to their customers or industries with significant exposure. This can help credit officers assess the potential threat. For instance, negative news about climate change impact on coastal properties tied to a real estate builder who borrows from the bank should be picked up by the early warning framework, even if it is not direct news of financial losses, a ratings downgrade or bankruptcy.

Credit risk modeling: Credit risk models like probability of default (PD) and loss given default (LGD) need to be calibrated to include climate change-related risk factors by factoring in their correlation to defaults or anticipated defaults. Securities or assets tied to climate-sensitive businesses or guarantors with elevated credit-risk profiles need to be factored into the LGD models. While a lack of observed historical data is a huge challenge when working to draw robust inferences, simulation models with anticipated impact can help factor in the impact on credit risk models.

Stress testing and capital management: Stress-testing scenarios, both from a portfolio perspective and from a regulatory capital-management perspective, need to factor in climate change impacts.  Ideally, these scenarios should be designed to assess the impact of default of large individual borrowers, as well as the portfolio impact due to macro effects of climate change on specific industries or geographies.  Calibration of PD and LGD models would help with credit loss provisioning and economic capital computations.

Credit risk reports and dashboards: Credit risk metrics sensitive to climate change need to be very closely monitored and reported to senior management and the board.  Exposures with climate sensitivity should ideally be tagged in the systems of record, and also sliced and diced across multiple dimensions of credit risk management. Climate risk reporting should not be viewed purely from the lens of regulatory disclosure – it should be deeply embedded in the key credit-risk metrics.

Climate’s impact on credit risk management is already being realized, and it is expected to grow exponentially. Financial services firms that take a proactive approach to assessing the impact to the balance sheet and work toward calibrating their credit risk frameworks are going to be better positioned to minimize their credit losses, and also play a key role in being change agents in the transition toward a greener planet.

Manoj Reddy is North America head of bank and financial services risk and compliance for Tata Consultancy Services.