Integrating Climate Risk into Banks’ Credit Risk Management Framework: Strategies and Considerations

Banks are facing increasing pressure to address climate risk and decarbonize their portfolios, with many institutions revamping their market and product strategies to align with sustainability goals. From prospecting and origination to underwriting and approval, banks are being urged to integrate climate risk assessments into their credit processes.

Prospecting and origination are key areas where banks can begin assessing the impacts of climate risk on clients’ credit risks. By analyzing sector concentrations, exposure by region, and ESG metrics, banks can better understand the climate risks associated with their clients. This information can then be used to enhance risk profiles and create more precise risk assessments.

Underwriting and approval processes are also being reshaped to include climate risk assessments. Banks are developing climate risk scores for borrowers and integrating climate risk assessments into their credit rating processes. By scrutinizing factors such as decarbonization progress and resiliency to climate change, banks can better evaluate the climate risks associated with their clients.

Collateral management and hedging are areas where banks are facing new challenges related to climate risk. With limited opportunities to transfer climate risks and a lack of data on carbon intensity, banks are working to develop new strategies to hedge climate risk. Stress tests and scenario analyses are being used to assess the impact of climate risks on credit portfolios.

Portfolio monitoring and management are also being impacted by climate risk considerations. Banks are 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 key performance indicators. By accounting for stranded assets and considering secondary and tertiary impacts of climate change, banks can better manage their credit portfolios in the face of climate risk.

Overall, banks are being urged to take a proactive approach to integrating climate risk into their credit risk management framework. By educating board members and senior managers, setting emission reduction targets, enhancing disclosures, and embedding climate risk into strategic planning, banks can work towards a carbon-neutral future. While the task may not be easy, addressing climate risk is becoming increasingly essential for banks looking to transition to a net-zero economy.