Climate risk and banking: What more should banks do?

May 29, 2019

A blog post by Val Srinivas, Banking & Capital Markets research leader at the Deloitte Center for Financial Services, Deloitte Services LP

Humans and banks alike can no longer ignore climate change

Climate change has become the defining challenge of our times.¹ There is increasing evidence that climate change is real.² Its adverse impact on the environment, human life, and the economies is undeniable. Consider some of the staggering costs of dealing with climate change:

• By 2100, rising sea levels could cost the world $14 trillion a year³; and the US economy could shrink by as much as 10 percent, and growth may decline by a third.⁴
• Developing countries have already paid more than $40 billion in additional interest to their creditors because of their exposure to climate risk.⁵
• 20 percent of the value of listed companies worldwide could be exposed to climate risk.⁶
• Expected losses to the pool of global investment assets, in net present value terms, could be as much as $4.2 trillion by 2100.⁷
• In addition, according to a recent paper by a senior policy advisor at the Federal Reserve Bank of San Francisco, "climate-related financial risks could affect the economy through elevated credit spreads, greater precautionary saving, and, in the extreme, a financial crisis."⁸

No surprise then that world leaders, for the third consecutive year, ranked environmental threats as the biggest risks to the world, according to the World Economic Forum’s latest Global Risks Report.⁹

The banking industry is not immune, given the potential wide-ranging consequences from climate change. A recent Fed report found that the effects of climate change have a “pervasive effect” across all sectors of the US economy, including the banking industry.¹⁰

At the individual bank level, the effects of climate risk could impact many products in the portfolio, including loans, derivatives, and investments. Potentially, there could be trillions of assets “at risk” from climate change.

The international banking community takes aim at managing climate risk

In responding to this growing challenge, central banks around the world, including the Federal Reserve, the European Central Bank, and the Bank of England, are not only examining the implications for monetary policy but are also seeking ways to “bolster banks’ resilience amid economic disruptions caused by extreme weather.”^11,12 Reflecting the fact that climate risk is a global challenge and that managing financial risk emanating from climate change will require a global response, leading central banks have also organized a new Network for Greening the Financial System, whose main intent is “to help strengthen the global response required to meet the goals of the Paris agreement, and to enhance the role of the financial system to manage risks and to mobilize capital for green and low-carbon investments.”¹³

Meanwhile, the Financial Stability Board established the Task Force on Climate-related Financial Disclosures (TCFD), which, in 2017, made recommendations for “disclosing clear, comparable, and consistent information about the risks and opportunities presented by climate change.”¹⁴

From the industry side, meeting these TCFD recommendations is no doubt a good first step.¹⁵ But many banks are already committed to improving the environment, and are doing quite a bit already to combat climate change, including the reduction of their carbon footprint, financing low-carbon businesses, promoting “Green Bonds,” and being transparent about their environmental practices. And, some, like ING Bank in the Netherlands, are also taking specific steps in their lending businesses to impact global agreements such as the Paris Accord on climate control.¹⁶

But can banks do more to fully account for climate risk?

Typically, banks have addressed climate change from a corporate social responsibility perspective rather than a risk management agenda.¹⁷

But for banks to manage climate risk effectively, not only is there a dire need for new, robust frameworks and analytical approaches, but common taxonomies and data standards need to be in place as well. Gathering relevant data to support the analysis of the impacts of climate change across markets, sectors, and geographies will be another major undertaking, as will the adoption of scenario analysis and the development of new quantitative models to stress test the effects of climate change on various activities, including lending.

Furthermore, according to Sabine Lautenschläger, a member of the Executive Board of the European Central Bank, developing “forward-looking risk strategies with a longer time horizon than banks commonly use for assessing ‘traditional’ risks” is important.¹⁸ And so is the understanding of the relationship between climate risk and other risks.

Such changes in risk management and governance to fully account for climate risk will not happen overnight, but the good news is there are efforts underway to develop methodologies to assess the risks and opportunities associated with the transition to a low-carbon economy.¹⁹ But to enable quicker progress, regulators should provide clear guidance and facilitate the sharing of best practices across jurisdictions and banks. Global coordination among regulators and the within the banking industry is a must to be truly effective.

Treat climate risk and traditional banking risks equally

Clearly, the banking industry needs to address the complex challenges climate risk poses to the world and make climate risk management an independent and robust discipline like credit risk or operational risk.

In this regard, boards, CEOs, and CROs can play a crucial role in providing leadership on climate risk management by placing climate risk high on the agenda and shaping their institutional responses.

Addressing climate risk in a proactive fashion will also help banks meet client needs, who will be increasingly looking to the them for guidance and understanding of various impacts from climate risks on their financial and business profiles.

I do hope the evidence for action is compelling. In my view, the banking industry is well advised to act quickly. While the most acute consequences of climate risks may seem far way, there is not much time to waste.