The looming risk for banks: biodiversity loss has been saved
The looming risk for banks: biodiversity loss
Exploring why the management of biodiversity loss is crucial for financial risk management
Society faces a critical juncture in one of the defining challenges of our time: the loss of biodiversity. It places severe costs on our economy. Stakeholders require information regarding their exposure to nature-related risks, and how entities are improving resilience across strategic, operational and financial dimensions. But how does biodiversity loss impact financial institutions?
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- Introduction to biodiversity
- Ecosystem services & biodiversity
- Financial risks for financial institutions stemming from biodiversity loss
Introduction to biodiversity
According to the World Economic Forum , biodiversity loss is considered to be among the top global risks currently faced by society. Although not immediately obvious, the loss of biodiversity and ecosystems also impacts financial institutions. According to the recently published study of De Nederlandsche Bank (DNB), the Dutch financial sector has a very high dependency on biodiversity with an exposure of EUR 510 billion across the globe. This blog describes how financial institutions are impacted by the risks associated with biodiversity loss and the potential challenges banks might face in mitigating these risks.
Ecosystem services & biodiversity
Ecosystems and biodiversity provide a variety of services to humanity, such as climate regulation, nutrient cycling, biomass production, and carbon capture. In fact, our water and food supply strongly depend on biodiversity. A variety of animal and plant organisms provide much needed pollination, water filtration, and water retention services. Moreover, healthy soil and nutrient cycling is vital for agricultural production and depends on well-functioning ecosystems.
Several sectors rely on the availability of biodiversity for their continuity and existence, including the clothing, timber, and fisheries sectors. However, there are also secondary effects of biodiversity loss that can negatively impact sectors. Habitat destruction and general biodiversity loss increase the risk of severe droughts, newly emerging diseases, the disappearance of animal pollinators and the collapse of fisheries and agricultural yield. It is therefore clear that biodiversity loss has a severe impact on several sectors dependent on biodiversity, which is also expected to result in losses for businesses providing services to these sectors.
Financial risks for financial institutions stemming from biodiversity loss
By financing clients with economic activities dependent on biodiversity, lending institutions are exposed to direct and indirect risks associated with biodiversity loss. These risks include transition and physical risks.
Transition risks include new regulations and policies aimed at creating a more sustainable future, which might lead to restrictions on certain economic activities. These restrictions might involve significant costs or loss of business opportunities for clients, leading to decreased profitability for those clients. Customer preference for greener products might also result in reduced profitability and increased risk for financial institutions.
Secondly, physical risks occur where clients are dependent on ecosystem services. These clients are likely to experience a decline in profitability as biodiversity decreases. Reduced profitability is expected to translate into a lower ability to meet financial commitments, such as loan repayments. This means that banks might observe higher default rates, higher loan loss provisions, higher capital requirements and ultimately even lower new business rates.
This means that it is important for banks to include biodiversity, and the tangible transition and physical risks, in their financial risk management systems. Banks might face challenges with respect to managing financial risks stemming from biodiversity loss such as strategic direction, risk quantification and collecting the relevant data required for assessing the expected impact:
- Strategic considerations include the link with the organisational strategy and purpose, setting an appropriate risk appetite and defining practical and measurable KPIs on how to transition clients towards a more sustainable and biodiverse economy. The Task Force on Climate-related Financial Disclosures (TCFD) can help to serve as a framework for financial institutions.
- Risk quantification involves determining the expected quantitative impact of biodiversity loss on the bank, given the current exposure as well as after possible mitigating actions. A first step to ensure a more sustainable future with respect to biodiversity is to understand the impact of biodiversity loss. Scenario analysis and stress testing are useful tools to assess the impact, but should be supported with business logic and knowledge about the client portfolio.
- The availability of the required data to assess the expected impact of biodiversity loss remains a challenge, as the required data has often not been captured by banks in the past. Data requirements include, for example, geographic areas where there is an increased risk of biodiversity disruption, or information concerning business activities that negatively impact biodiversity.
It is clear from the above that biodiversity loss will have a critical impact on financial institutions and their clients if ignored. Financial institutions should act now and assess their exposure to the loss of biodiversity and ecosystems. This enables them to mitigate these risks in time, become more purpose driven and contribute to a more sustainable economy.
Although addressing the risks associated with biodiversity loss can seem overwhelming, it is important to stay grounded in the context of your organisation. Our advice is to start small. Have conversations with your clients and stakeholders on the impact of biodiversity loss, understand the local biodiversity implications and progress together from there.
If you would like to start a conversation on biodiversity loss and your business, please feel free to contact Anne-Claire Van den Wall Bake-Dijkstra or Gerdie Knijp via the contact details below.