Strategies for Banks to Integrate Climate Risk into Credit Risk Management

Banks are facing increasing pressure to account for climate risk and decarbonize their portfolios, with many institutions expanding their green-lending products to offset financed emissions. This shift towards sustainable finance is crucial in the fight against climate change, but it comes with its own set of challenges.

Revamping market and product strategy to align with climate goals can be difficult due to the uncertainty and complexity of translating climate scenario projections into microdecisions at the borrower level. Additionally, teams must navigate differences across jurisdictions, products, and counterparties when forecasting economic outcomes and sector impacts.

Prospecting and origination processes should now include assessments of physical and transition risks on clients’ credit risks from the onset of new relationships. This involves analyzing sector concentrations, exposure by region, and new types of data like energy usage and emissions per unit of revenue.

Underwriting and approval processes are evolving to incorporate standalone borrower-specific climate risk scores and integrate climate risk assessments into standard credit rating processes. Banks are using tech tools and data applications to enhance risk assessment and better understand each client’s climate response.

Collateral management and hedging are areas that require greater attention, as both physical and transition risks can affect collateral values. Banks are encouraged to infuse climate risk assessments into collateral policies and stress tests to adjust collateral requirements and demand risk mitigation from counterparties.

Portfolio monitoring and management involve developing new methodologies to quantify climate risk at the borrower and portfolio levels, conducting stress tests using different climate scenarios, and integrating climate risk drivers into risk models.

Sector-specific considerations within bank portfolios are crucial, as different industries face unique climate risks. Banks should adopt a sectoral approach to analyzing climate risk in their credit portfolios and evaluate how extreme weather events could impact loan-to-value ratios.

Working with third parties to integrate climate risk into credit risk management is essential, as banks may need to supplement internal capabilities with external expertise. Credit rating agencies, regulators, and research institutions are collaborating on climate projections and developing new metrics to assess climate risk.

Overall, banks must prioritize coaching and educating board members and senior managers on climate risk, setting emission reduction targets, enhancing disclosures, and performing stress tests with longer time horizons. Embedding climate risk into credit risk management frameworks will be crucial in transitioning to a net-zero economy.