By Manoj Reddy, Head of BFS Risk & Compliance & LIBOR Transition Practice for TCS (TATA CONSULTANCY SERVICES) in North America

Global Impacts of Climate change are becoming increasingly observable in the last few years and is expected to proliferate in the coming years. The economic and financial losses that can be attributable to the changes in environment is broadly referred to as Climate Risk.  It is applicable to virtually any organization across Industries but there is growing realization of its impact now on the Banking and Financial services Industry and the pressing need to identify and manage it. At a very broad level banks could be exposed to climate risk by way of (i) their lending to, and investments in entities whose sustainability and revenue earning potential is compromised by climate change, and (ii) potential losses to its own operations and sustainability owing to climatic changes.

Also, Climate Risk on account of impact to the obligor and investee entity can be attributable to two channels or sources, Physical and Transitional.  Physical risks are potential losses on account of climatic change events or environmental changes and Transition risk are potential losses on account of an organization transitioning to a low carbon footprint policy or technology and transforming into a more climate resilient entity.   Very few banks at this point of time may have climate risk identified as a material risk type in their Enterprise Risk Management framework.  Infact, it should not come as a surprise if they are not a significant part of any scenario analysis or stress testing frameworks being used by Banks today.  The biggest challenge for Banks has been the availability of reliable data to be able to construct a robust framework for climate risk.   Those Banks that have identified Climate risk as a material risk type are working towards strengthening their framework across key dimensions such as Governance, Risk Management & Disclosures.

Key dimensions for a Holistic Climate Risk Framework

Cross Impacts of Climate Risk across Primary & Secondary Risk Types

Though climate risk needs to be recognized and managed as a separate risk type by itself, with its own independent risk management framework, we still need to understand and calibrate its cross impact on the other primary and secondary risk types which are a part of the overall enterprise risk management framework.  Below are some of the high-level cross impacts on other risk types and recommended practices to be incorporated to manage climate risk.

Credit Risk –   For Banks, Credit Risk is one of the biggest risk category which has a huge cross impact from climate risk since climate risk primarily impacts obligor’s business performance, eventually having an unavoidable bearing on their credit worthiness and their ability to service or repay their loans extended by the Bank.   The key areas of impact within Credit risk are-

• Credit Rating – Some of the climate risk metrics intended to be captured from obligors need to be factored into the credit rating process. These metrics could be assigned a certain weightage in the rating model for them to be appropriately factored into the credit risk assessment process.  Even a customer declaration of intent to transition to more sustainable forms of energy and sustainable sources could be qualitatively factored into the Rating process.   Also, in addition to obligor’s Probability of default (PD) ratings the facility Loss given default (LGD) rating needs to be calibrated for potential impact of climate risk events on the value of collaterals extended to secure the underlying loans.
• Credit Polices – Credit Policies largely determine the composition and quality of portfolios for banks, hence these policies can be reviewed and updated to limit further exposure to sectors and geographies which have an elevated climate risk profile. Also, credit policies need to be updated to promote lending to those sectors and geographies which are transitioning over to more sustainable sources and making their businesses climate resilient.

• Credit approval & monitoring Process –  In addition to policies, Banks need to ensure that they are able to control the quality of credit approved to customers with elevated climate risk profile by adding appropriate financing conditions and covenants.  This will ensure that the loans are constantly monitored for their original terms of approval.    Also, the frequency of credit review for such customers should be relatively higher.  Banks could leverage capabilities such as early warning signals through negative news screening for critical insights as a very effective tool to screen for climate risk events and impacted customers in their Credit approval and monitoring process.

• Stress testing – The key business objective of stress testing is to make Banks more resilient to unforeseen and adverse business environments.  Banks should introduce climate risk a key dimension for stress testing and introduce multiple stress scenarios (base, adverse and severely adverse) of climate risk events and forecast the impact on their credit portfolios to review and alter the credit policies as needed.

Market Risk –   If the investment portfolio of Bank is comprised of financial instruments issued by entities which have elevated climate risk profiles, this can significantly impact the value of the securities and the profitability of the portfolio.   Banks should review their Investment policies in asset classes, sectors and geographies which are vulnerable to climate change events and set appropriate limits to mitigate the losses specially on portfolios with longer term investment horizons.   It important to factor in stress testing scenarios and market shocks attributable to climate change events to value the Investment portfolios on a regular basis.

Liquidity Risk –   There will be increasing impact witnessed in the liquidity risk area owing to climate risk, as there is likely to be distressed withdrawal of committed lines of credit and funds by obligors impacted by climate change events.  Also, liquidation of some of the assets impacted by climate events can have impact on anticipated cashflows in the overall liquidity management process.

Operational Risk –   Operational Risk will need to take a more intrinsic and direct view of the impact of climate risk to the Bank on account of impact to the operations.  Any impact to people, process or systems due to climate change events can disrupt operations and needs to be accounted for as potential operational loss events.  For instance, if Banks have Branches and data centers in geographies which are susceptible to climate change, then it can severely impact the operations and these need to be identified and managed as potential operational risk events.  Operational Risk managers along with the process owners will need to identify risks that could be triggered by climate change and identify suitable controls to mitigate it.  The Risk Controls Self-assessment (RCSA), KRIs and Scenario analysis process need to factor in climate change events to ensure operational risk management is adequately insulated for the cross impacts of Climate Risk.

Manoj Reddy

Reputational Risk –   With climate risk related disclosures becoming more prominent and visible over the coming years, Banks that are unable to, or perceived to be unable to foster growth and funding towards low carbon footprint economy and continue to lend to customers with elevated climate risk profiles could potentially be subject to higher degree of reputational risk.  With world leaders and public perception building strongly towards climate change, banks would want to ensure they are moving and contributing towards a greener planet to safeguard their reputation and potentially even ameliorate it by being vocal about their policies and disclosures.

Political & Legal Risk –   In the coming years, the political dispensation along with national regulations across the globe are likely to introduce local regulations to fight climate change which will require banks to be cognizant of not just the impact to their customer and investees, but also of their own regulatory and legal compliance to regulators and the laws of the geographies they operate in.  Failure to comply with regulations could increase legal risk and further extent to reputational risk as well.

Business & Strategic Risk –   Banks in their Business strategy planning will need to factor in sustainability in addition to Business growth and profitability. Business decisions and strategy on which geographies to operate in, and the kind of services and products extended to certain sectors and geographies need to be reviewed and designed with a forward looking focus towards funding environment friendly projects and initiatives to ensure Business and strategic risk is minimized.

Conclusion

Climate risk is here to stay and its likely to enter the mainstream of Enterprise risk management as we globally continue to witness the devastating impacts of climate change.  With increase in bankruptcies, diminishing earning potential, and lowering credit standing of customers attributable to climate change, and regulatory expectations on disclosures will compel Banks to establish a robust Climate Risk Management framework.  These frameworks will gain maturity as the quality of Industry data for impacts of climate is available and can become actionable to be incorporated into the models and business processes of Banks.    Banks have a very important role to play in the battle against climate change by not only minimizing its impact on its stakeholders but also being catalysts for transition by way of lending and investing in low carbon footprint sectors and entities.

About the Author

Manoj Reddy is the Head of BFS Risk & Compliance & LIBOR Transition Practice for TCS (TATA CONSULTANCY SERVICES) in North America with an experience of more than 17 years in the areas of financial services, IT, and business consulting. Reddy has led several risk & regulatory consulting and implementation engagements for financial firms globally. He has provided both Regulatory and Strategic Business solution to his customers over the last decade primarily in the area of Enterprise Risk management across all major risk types and leading regulations such as, CCAR, Basel and Liquidity Risk.  He is currently leading TCS efforts in North America with respect to providing Business & technology solutions to BFSI customers in the Risk Management and LIBOR transition space.