By Yugal Yadav
In an era marked by escalating climate change impacts, the financial sector finds itself at the forefront of addressing the associated risks. Climate change introduces a new dimension to credit risk management, urging financial institutions to adopt holistic strategies to safeguard their portfolios. This blog explores the concept of climate resilience and outlines a comprehensive roadmap for banks to integrate climate considerations into their credit risk management framework.
Understanding climate risk
Climate risk encompasses a range of challenges – physical risks such as extreme weather events, sea-level rise, and shifts in temperature patterns. These risks have cascading effects on businesses, communities, and, by extension, the financial institutions that support them. Transition risk encompasses climate-related developments in policy and regulation, the emergence of disruptive technology or business models, shifting sentiment and consumer preferences, or evolving evidence, frameworks, and legal interpretations.
Assessment and scenario analysis
To effectively manage climate risk, banks need to conduct thorough assessments and scenario analyses. This involves evaluating how climate-related factors may impact different industries, regions, and types of businesses. By simulating various climate scenarios, banks can identify vulnerable sectors and tailor their risk management strategies accordingly.
Integration into credit policies
Climate resilience cannot be achieved without a fundamental shift in credit policies. Banks therefore need to revise their lending criteria to incorporate climate risk considerations. This may involve adjusting loan terms, interest rates, or collateral requirements based on a borrower’s exposure to climate-related risks. By embedding climate considerations into credit policies, banks align their lending practices with long-term sustainability goals.
Enhanced due diligence
Holistic credit risk management necessitates enhanced due diligence processes. Banks must thoroughly assess the climate resilience of potential borrowers, taking into account their adaptation strategies, exposure to climate-related risks, and commitment to sustainable practices. This ensures that loans are extended to businesses that demonstrate a proactive approach to climate resilience.
Stress testing for climate scenarios
Stress testing is a crucial tool for evaluating a bank’s resilience to adverse economic conditions. In the context of climate risk, stress testing should include scenarios related to physical and transition risks. By stress testing their portfolios for climate scenarios, banks can identify potential vulnerabilities and implement pre-emptive measures.
Capacity building and collaboration
Building climate resilience requires expertise. Banks therefore need to invest in training programs to equip their staff with the necessary skills to navigate the complexities of climate risk management, and build climate confident teams.
Disclosure and reporting
Banks need to adopt robust disclosure practices, providing stakeholders with comprehensive information about their exposure to climate risks and the measures taken to address them. At OakNorth for example, we published our first ever Task Force on Climate-Related Financial Disclosures (TCFD) report in 2023 which disclosed our reporting, governance, and future targets.
As climate change continues to pose significant challenges to the global economy, banks must evolve their approach to credit risk management. Integrating climate resilience into their strategies not only safeguards their financial interests but also contributes to the broader goal of building a sustainable and resilient future. By following the outlined roadmap, banks can proactively address climate risks, demonstrate their commitment to responsible banking, and play a crucial role in advancing global climate resilience efforts.
(The author is Yugal Yadav, Senior Director at OakNorth, and the views expressed in this article are his own)
