Impact of Climate Change on Credit Risk

For now, and the near future, banks unanimously recognize that climate change shall overall result in increased credit risk, whether through flash events (e.g. flood, earthquake, tsunami) associated with physical risk or through chronic phenomena (e.g. rise in sea-level or temperature, soil erosion) related to transition risk.

Flash events may suddenly reduce the ability of borrowers to repay their credit facilities, due to abrupt damage to productive infrastructure but the impact may be limited to such time as until repairs are done. Of note, the flash events may hit again if enabling infrastructure, like drainage system and road flood-proofing in case of flash flood, continue to be inadequate.

Therefore, flash events are likely to have a short-term but potentially acute impact on credit risk and recur if inadequate infrastructure prevails, possibly with increasing severity over time.

Chronic events, on the other hand, have a long-term steady credit risk impact over time. An impact that is likely to persist and which may be countered by the construction of required infrastructure. For example, reinstating vegetation and rocks along the coast to mitigate sandy beach erosion.

The differing impacts of physical and transition climate risks on credit risk, in terms of duration and magnitude, require banks to adopt a suitable strategy in their modelling of default probability. The model architecture would need to explicitly consider climate-related variables, both qualitative (e.g. flash flood or cyclone occurrence) and quantitative (e.g. temperature or rainfall measure). In addition, the models should preferably use granular (facility-level monthly) data and be formulated across sectors or segments based on shared credit risk characteristics.

Failure to capture these climate-related impacts on credit risk would result in biased estimates of default probability (PD), most likely underestimates.

Climate Change has an impact on loss given default (LGD) as well, especially where facilities are secured by land or property in vulnerable areas. The (discounted) economic value of such assets would fall due to physical and transition risks, but quantifying such reduction from a model at the present early stage of climate awareness would be a challenge as the market typically has not factored in the climate dimension while performing valuations historically. The banking regulator may have to provide banks with benchmark reduction rates to apply to the values of such assets, at least for a couple of years. Else the Board of Directors of banks could take the initiative of formulating these rates. After a couple of years, LGD models may be designed to estimate the rates explicitly from hard data.

Climate Change should have a definite impact, most likely increasing, on PD and LGD. Failure to account for this would result in an underestimate of IFRS9 ECL (Expected Credit Losses), breach the prudence concept and lead to an overestimate of bank profits. Banks should upgrade their modelling infrastructure to account for the potentially important impact of Climate Change on credit risk, in order to portray a true and fair view of their financial situation.

At OptiFin Solutions, we have the necessary expertise and credentials to upgrade the credit risk models of banks for capturing the impact of Climate Change in an agile manner at a granular level.