Quantifying climate change-related credit risk in banking has been saved
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Quantifying climate change-related credit risk in banking
A case study of a mortgage portfolio in the United States
It is increasingly important for banks to measure the financial risks related to climate change. Financial regulators consider climate risk as an emerging risk. Banks are expected to incorporate climate risk in their risk management practices. Furthermore, multiple regulators have announced stress tests on climate risk. Once specific climate risks are identified, how can risk managers quantify these in their loan portfolios?
Why opt for climate risk modelling?
Climate change impacts today’s world. To prevent any permanent, devastating consequences, a fundamental change to a more sustainable growth path is required. Financial regulators recognise that such a change may impact the stability of economies, and financial institutions need to identify, quantify and mitigate the financial risks related to climate change where the financial sector is impacted. Financial institutions as well as regulatory authorities are exploring methods for quantifying these climate risks, which can be divided into physical risks (direct results of climate change, such as extreme weather events), and transition risks, which are related to the transition into a more sustainable, low carbon economy (e.g. changes in consumer preferences and costs of raw materials).
Climate change related credit risk: Case study for U.S. mortgage loans
Case study: climate risk and mortgage portfolio
Climate change impacts today’s world. To prevent any permanent, devastating consequences, a fundamental change to a more sustainable growth path is required. Financial regulators recognise that such a change may impact the stability of economies, and financial institutions need to identify, quantify and mitigate the financial risks related to climate change where their portfolio is impacted. Financial institutions as well as regulatory authorities are exploring methods for quantifying these climate risks, which can be divided into physical risks (direct results of climate change, such as extreme weather events), and transition risks, which are related to the transition into a more sustainable, low carbon economy (e.g. changes in consumer preferences and costs of raw materials).
Results
The results show the impact of flood risk on the PD of mortgage loans and the impact of transition risk scenarios on the portfolio default rate. The study also contains useful considerations and next steps. Now that regulatory requirements are taking shape, institutions should develop methods to quantify climate related risks for their exposures. This study can serve as an example of how climate related risks can be incorporated in PD modelling for a specific portfolio. For more detailed information, please download the full study.
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