How Banks Can Better Manage Climate-Related Financial Risks

Since GARP’s earliest articles on the topic, we have argued climate risk management should be treated like traditional risk types and embedded into the standard framework of risk identification, measurement, management, and monitoring. A recent UNEP FI publication on managing physical climate-related risks in loan portfolios, part of its Climate Risk Landscape series, is helping risk managers do just that by describing specific responses and actions they can have within the typical risk management framework.

Standard risk management consists of accepting risk, avoiding risk, and mitigating risk. These approaches are applied in the proposed framework (see Figure 1), with mitigation split into two sub-categories: (i) adapt — risk reduction via adaptation of the built environment which increases the resilience of the client and/or their assets, and (ii) transfer — risk reduction via either the bank or its customers transferring the risk to others.

Traditionally the aim of risk mitigation has been to protect the bank’s balance sheet. While that is still a primary aim in this framework, it is noteworthy that assisting customers to adapt to more frequent and severe weather events associated with climate change is posited as a way of achieving this.

The publication states that costs due to physical risks arise not just from direct damage to an asset but also from the financial costs associated with responding to the catastrophe, as well as the social costs from impacts on mental and physical health, as shown in Figure 2. These indirect financial and social costs can impact a borrower’s ability to repay loans.

Many banks, especially those with regional concentrations, already respond to natural catastrophes with measures that help their customers deal with not just the asset damage but also the financial and social costs. These actions make sense from a risk mitigation perspective in a number of ways, including increasing the likelihood of repayment, building resilience against future events, and fulfilling banks’ duty of care obligations to their customers.

UNEP FI gives some helpful examples of banks — including ANZ, BBVA, Bank of Ireland, Desjardins and NAB — that provide short-term payment relief to customers affected by such catastrophes. For example, ANZ donates to municipal initiatives to build community resilience; Desjardins provides emergency loans to cover clean-up, security and other costs and donates to national relief organizations; and NAB provides grants and donates to fund recovery programs.

This broader response from banks can be incorporated into risk management techniques to deal with climate risks by adding a new dimension. This captures that banks aren’t just directly protecting their own balance sheet, but are also helping their customers to withstand the impacts of increasing climate-related risks. By so doing, banks maintain their reputation and customer base, as well as decrease the risk of financial distress and the corresponding arrears and defaults.

The new dimension for the risk framework has four stages, which start before a catastrophe occurs and continue through it unfolding onto the recovery period. They are:

1. Loss Prevention: Steps that can be taken at an individual asset or community level to reduce the effects of natural catastrophes.
2. Event Preparedness: Preparedness plans created to establish arrangements in advance to enable timely, effective, and appropriate responses to specific potential hazardous events.
3. Event Response: Measures and actions taken during a natural catastrophe to protect affected populations and assets.
4. Recovery: Actions that focus on restoring, redeveloping and revitalizing communities impacted by a catastrophe.

The publication also helpfully sets out actions that banks can take to accept, avoid, adapt and transfer risk for each of the four stages, along with the benefits to customers (Figure 3).

Let’s focus on the top three:

1. The research found that resilient loans (used in the prevention and recovery phases of adaptation) that either help prevent damage or build back better after a catastrophe were the most beneficial, from the combined perspective of both the bank and the borrower. These loans help borrowers or communities make their assets more resilient to climate change. For example, they could strengthen buildings, so they are more storm proof, or waterproof basements to decrease the damage from flooding. Alternatively, they can be structured to help clients build back better after a disaster has struck and increase the catastrophe resilience of replacement buildings.
2. Interestingly, the next best risk management approach was found to be accumulation monitoring, in the prevention phase of risk acceptance. This is where a bank monitors its potential exposure to physical risks from natural hazards and climate change, although this benefits a bank much more than it benefits the customers.
3. The third most useful approach is repayment holiday insurance (used in the response phase of risk transfer), which pays customers’ interest and/or principal for a given period, thereby benefitting both banks and their customers.

A description of all the actions can be found in the UNEP FI publication.

Parting Thoughts

As global greenhouse gas emissions continue to rise, we can expect the number and severity of physical hazards to continue to increase. Risk managers will therefore need to keep up to date with the risk management approaches that their peers are using — especially those that are beneficial for both a banks and its borrowers — so that they not only manage their firms’ risks well, but also maintain market share and a reputation for products that are most effective for the real economy.

Maxine Nelson, Ph.D, Senior Vice President, GARP Risk Institute, currently focusses on sustainability, climate and nature risk management. She has extensive experience in risk, capital and regulation gained from a wide variety of roles across firms including Head of Wholesale Credit Analytics at HSBC. She also worked at the U.K. Financial Services Authority, where she was responsible for counterparty credit risk during the last financial crisis.