Climate-related risks for banks are physical and transitional risks that impact their financial health. They result from the effects of physical and transitional climate risks on the various sectors of an economy and how that impacts a bank’s financial condition.
As a result, banks have to develop risk management practices to manage these climate-related risks and incorporate them into their overall risk management framework.
Banks need to understand the short-, medium- and long-term impacts of climate risks on their organisation. It includes collecting all relevant data to analyse the bank’s exposure to climate risks.
It also requires a clear definition of roles and responsibilities across the organisation’s structure to deal with climate risk, particularly across the three lines of defence—management, risk management and compliance, and internal audit functions.
The internal audit function should involve reviews of the following areas for compliance with the bank’s stated policies: materiality assessment, strategy, commitments, product offerings, stress testing, and disclosures.
Another essential practice is incorporating climate risk into the bank’s overall risk appetite framework using quantitative and qualitative key risk indicators (KRIs)—metrics used to measure the probability of an event and its impact exceeding the bank’s stated risk appetite.
For climate-related financial risk management, KRIs can warn banks of potential financial exposures arising from climate risk, and provide insights on weaknesses around controls on climate-risk management.
Some KRIs that could be applied include financed emissions, quantitative exposure limits at sectoral or geographic levels (absolute and relative amounts), and portfolio (mis)alignment ratios when compared to the transition scenarios the bank applied.
In addition, banks should integrate climate risks to assess capital adequacy for credit, market and operational risks through the Internal Capital Adequacy Assessment Process.
They should also incorporate climate risks in their loan origination and monitoring processes, including their loan pricing framework, to develop green products.
Another critical aspect is incorporating physical and transition climate risk drivers in the valuation and management of collateral held by banks. For example, property held as collateral requires information on its location and energy label.
Banks should also perform credit risk modelling, scenario analysis, and stress testing for their portfolio.
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