Climate Risk in Banking: Assessing and Incorporating Risks for a Sustainable Future

As the world faces increasing environmental challenges, it's vital for banks to consider the implications of climate risk in their loan origination and credit risk management processes. Climate risk encompasses both physical risks and transition risks, which can have significant impacts on borrowers' creditworthiness. In this blog, we'll explore the concept of climate risk, why it's important for banks to assess, and how they can incorporate it into their lending and risk management practices while adhering to the European Central Bank (ECB) expectations.

Climate risk is divided into two main categories: physical risks and transition risks. Physical risks result from the direct impacts of climate change, such as extreme weather events, flooding, or sea-level rise. An example of a physical risk is the phenomenon known as "pole rot" in the Netherlands. Due to changing rainfall patterns, wooden poles supporting buildings are increasingly exposed to water, leading to rot and potential structural damage. This can impact the value of collateral, increase the likelihood of default, and pose financial risks to banks.

Transition risks arise from the shift towards a low-carbon economy, including changes in climate policies, technological advancements, or shifting consumer preferences. An example of transition risk in the Netherlands is the shift from natural gas to renewable energy sources. As the government phases out natural gas, utility companies and property owners may face increased costs to retrofit buildings with alternative energy solutions. These risks can lead to regulatory changes, increased costs for carbon-intensive industries, or reduced demand for their products, affecting borrowers' creditworthiness.

Recognizing the importance of climate risk, European regulators, such as the European Central Bank (ECB) and European Banking Authority (EBA), have introduced guidelines to address these risks. The ECB Guide on climate-related and environmental risks and the EBA Guidelines on Loan Origination and Monitoring (GL_LOM) both emphasize the need for financial institutions to integrate climate risk assessments into their credit-granting processes and risk management frameworks.

To incorporate climate risk into their loan origination and credit risk management, banks should consider the six key ECB expectations related to climate risk:

1. Integrate climate-related and environmental risks into the credit-granting process: Banks should identify and assess the material climate-related and environmental factors affecting borrowers' default risk. For example, some institutions have developed climate-informed shadow probabilities of defaults (PDs), which consider both physical and transition risks.

2. Adjust risk classification procedures: Banks should define appropriate risk indicators or ratings that take into account climate-related and environmental risks. This can be achieved by using heat maps to highlight sustainability risks based on the relevance of individual (sub-)economic sectors for a given client.

3. Consider climate risks in collateral valuations: Banks should incorporate climate-related and environmental risks into both the process for establishing the value of collateral and into regular reviews. This includes considering the physical locations and energy efficiency of commercial and residential real estate.

4. Monitor geographic and sectoral concentration: Banks should monitor how their portfolios' geographic and sectoral concentrations are prone to climate-related and environmental risks. They can develop monitoring capabilities in conjunction with the metrics and limits developed for the purposes of their risk appetite and data governance framework.

5. Reflect climate risks in loan pricing frameworks: Banks should ensure that their loan pricing frameworks support their chosen risk perspective and strategy. This may involve differentiating loan prices for exposures according to their energy efficiency or by including a sector/client-specific charge. Institutions can also incentivize clients to consider climate-related and environmental risks by offering discounts on environmentally sustainable loans or linking interest rates to sustainability targets.

6. Reflect climate risk-driven costs in loan pricing: Banks should consider the various cost drivers impacted by climate-related and environmental risks, such as the cost of capital, funding, or credit risk, and reflect these developments in their loan pricing.

Note that incorporating climate risk into loan origination and credit risk management is not only a regulatory requirement but also a crucial step in promoting a sustainable financial system. By understanding and addressing the potential impacts of climate risk on their borrowers, banks can contribute to a more resilient and sustainable economy while managing their own financial risks more effectively.