How Climate Change Affects Banks and Why You Should Care

Climate change is one of the most pressing challenges of our time. It poses serious threats to the environment, the economy, and society.

But did you know that climate change also affects banks and their customers?

You might think that banks are immune to the effects of climate change, as long as they have enough capital and liquidity to weather any storm. But that’s not the case. Banks are exposed to climate change through various channels, such as credit risk, market risk, and lending standards. These risks can have significant impacts on banks’ profitability, stability, and reputation.

In this blog post, we will explain how climate change affects banks and why you should care. We will also share some insights from the latest research on this topic, conducted by the Basel Committee on Banking Supervision, a global forum for banking regulation and supervision.

By the end of this post, you will learn:

• What are the main types of climate change-related risks for banks
• How these risks affect banks’ credit and market exposures, as well as their lending behavior
• What are the potential macroeconomic and financial stability implications of climate change
• What are some of the challenges and opportunities for banks to manage and mitigate climate change-related risks

Ready to dive in? Let’s get started!

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What are the main types of climate change-related risks for banks?

According to the Basel Committee, there are two main types of climate change-related risks for banks: physical risk and transition risk.

Physical risk refers to the risk of losses or damages caused by extreme weather events (such as floods, droughts, heat waves, wildfires, hurricanes, etc.) or gradual changes in climate patterns (such as sea level rise, temperature increase, precipitation variability, etc.). These risks can affect banks directly, by damaging their physical assets or disrupting their operations, or indirectly, by affecting their borrowers, counterparties, or markets.

Transition risk refers to the risk of losses or damages caused by the process of adjusting to a low-carbon economy. This process may involve policy changes, technological innovations, shifts in consumer preferences, or social movements that aim to reduce greenhouse gas emissions and mitigate climate change. These risks can affect banks directly, by affecting their own carbon footprint or reputation, or indirectly, by affecting their borrowers, counterparties, or markets.

Both types of risks can have significant impacts on banks’ credit and market exposures, as well as their lending behavior. Let’s see how.

How do physical and transition risks affect banks’ credit and market exposures?

Credit risk is the risk of default or deterioration in the credit quality of banks’ borrowers or counterparties. Market risk is the risk of losses or fluctuations in the value of banks’ trading or investment portfolios due to changes in market prices or conditions.

Both types of risks can be affected by physical and transition risks in different ways. Here are some examples:

• Physical risk can increase credit risk by reducing the income, cash flow, or collateral value of borrowers or counterparties that are exposed to climate shocks. For instance, a flood can damage a borrower’s property or business, making it harder for them to repay their loan. Physical risk can also increase market risk by affecting the prices or liquidity of securities or commodities that are sensitive to climate shocks. For instance, a drought can reduce the supply or quality of agricultural products, affecting their market prices.
• Transition risk can increase credit risk by reducing the profitability, competitiveness, or solvency of borrowers or counterparties that are exposed to policy, technological, or behavioral changes related to the low-carbon transition. For instance, a carbon tax can increase the costs or reduce the demand for a borrower’s products or services, making it harder for them to repay their loan. Transition risk can also increase market risk by affecting the prices or liquidity of securities or commodities that are sensitive to the low-carbon transition. For instance, a shift to renewable energy can reduce the demand or value of fossil fuel assets, affecting their market prices.

These effects can vary depending on the type, severity, frequency, and duration of the climate shocks or changes, as well as the characteristics of the borrowers, counterparties, or markets involved. They can also interact with each other, creating feedback loops or amplification mechanisms. For example, a physical shock can trigger a policy change, which can in turn affect the market value of a security, which can then affect the credit quality of a borrower, and so on.

How do physical and transition risks affect banks’ lending behavior?

Lending behavior refers to the decisions and actions of banks regarding the supply, pricing, and terms of credit to their customers. Lending behavior can be affected by physical and transition risks in different ways. Here are some examples:

• Physical risk can affect lending behavior by changing banks’ risk appetite, risk assessment, or risk management. For instance, banks may become more cautious or selective in lending to borrowers that are exposed to physical risk, or they may charge higher interest rates or require more collateral or insurance to cover the potential losses. Banks may also adjust their loan portfolio composition, diversification, or hedging strategies to reduce their exposure to physical risk.
• Transition risk can affect lending behavior by changing banks’ incentives, expectations, or strategies. For instance, banks may become more proactive or supportive in lending to borrowers that are aligned with the low-carbon transition, or they may offer lower interest rates or better terms to encourage green investments or activities. Banks may also adjust their loan portfolio composition, diversification, or hedging strategies to take advantage of the opportunities or mitigate the risks related to the low-carbon transition.

These effects can vary depending on the type, timing, speed, and predictability of the climate shocks or changes, as well as the characteristics of the banks, borrowers, or markets involved. They can also interact with each other, creating spillovers or synergies. For example, a transition policy can affect the lending behavior of banks, which can in turn affect the credit and market exposures of banks, which can then affect the lending behavior of banks, and so on.

What are the potential macroeconomic and financial stability implications of climate change?

Macroeconomic and financial stability refers to the conditions and performance of the economy and the financial system as a whole. Macroeconomic and financial stability can be affected by physical and transition risks in different ways. Here are some examples:

• Physical risk can affect macroeconomic and financial stability by reducing economic growth, increasing inflation, or disrupting financial intermediation. For instance, a severe or frequent climate shock can damage infrastructure, disrupt production, or reduce consumption, leading to lower output, higher prices, or lower income. A widespread or systemic climate shock can also impair the functioning of the financial system, by causing defaults, losses, or contagion, leading to lower credit availability, higher funding costs, or lower confidence.
• Transition risk can affect macroeconomic and financial stability by creating structural changes, uncertainties, or trade-offs. For instance, a rapid or abrupt transition to a low-carbon economy can create winners and losers, opportunities and challenges, benefits and costs, for different sectors, regions, or groups. A delayed or insufficient transition to a low-carbon economy can also create risks of stranded assets, policy shocks, or social unrest, leading to lower investment, higher volatility, or lower trust.

These effects can vary depending on the scale, scope, and direction of the climate shocks or changes, as well as the resilience, adaptability, and coordination of the economic and financial agents involved. They can also interact with each other, creating nonlinearities or complexities. For example, a physical shock can affect the macroeconomic and financial stability, which can in turn affect the transition policy, which can then affect the macroeconomic and financial stability, and so on.

What are some of the challenges and opportunities for banks to manage and mitigate climate change-related risks?

As we have seen, climate change poses significant risks for banks, but also offers some opportunities. Banks face various challenges and opportunities to manage and mitigate climate change-related risks, such as:

• Data and information: Banks need reliable, consistent, and comparable data and information on the sources, drivers, and impacts of climate change-related risks, as well as the potential scenarios, pathways, and outcomes of climate change and the low-carbon transition. Banks also need to disclose their own exposures, strategies, and actions related to climate change, to inform their stakeholders and the public.
• Methodologies and models: Banks need robust, flexible, and forward-looking methodologies and models to measure, monitor, and manage climate change-related risks, as well as to assess their resilience, vulnerability, and alignment with climate goals. Banks also need to incorporate climate change-related risks into their risk governance, risk appetite, and risk culture, as well as their business strategy, product development, and customer relationship.
• Regulation and supervision: Banks need clear, consistent, and coherent regulation and supervision on the identification, assessment, and mitigation of climate change-related risks, as well as the promotion of green finance and sustainable development. Banks also need to comply with the existing and emerging regulatory and supervisory frameworks, standards, and expectations related to climate change, as well as to engage with the relevant authorities and stakeholders.
• Innovation and collaboration: Banks need to innovate and collaborate to seize the opportunities and overcome the challenges related to climate change. Banks can leverage new technologies, products, or services to enhance their efficiency, competitiveness, or profitability, as well as to support their customers, communities, or society in the low-carbon transition. Banks can also partner with other banks, financial institutions, or non-financial actors to share knowledge, best practices, or resources, as well as to create synergies, networks, or platforms.

These challenges and opportunities require banks to take action and to adapt to the changing environment and expectations related to climate change. Banks can play a key role in the transition to a low-carbon and resilient economy and society, by providing finance, advice, or solutions to their customers and stakeholders, as well as by managing and mitigating their own risks related to climate change.

Conclusion

Climate change is not just an environmental issue, but also a financial one. Banks, as key players in the financial system, are exposed to climate change-related risks through various channels. These risks can have significant impacts on banks’ credit and market exposures, lending behavior, and overall stability. However, banks also have opportunities to manage and mitigate these risks, and to contribute to the transition to a low-carbon economy.

Here are the main points we covered:

1. Types of Risks: Banks face two main types of climate change-related risks: physical risk and transition risk.
2. Credit and Market Exposures: Both types of risks can affect banks’ credit and market exposures in different ways.
3. Lending Behavior: Physical and transition risks can also affect banks’ lending behavior.
4. Macroeconomic and Financial Stability: Climate change can have potential macroeconomic and financial stability implications.
5. Challenges and Opportunities: Banks face various challenges and opportunities to manage and mitigate climate change-related risks.

P.S. What are your thoughts on how banks can better manage and mitigate climate change-related risks? Share your ideas in the comments below! We’d love to hear from you. Remember, every idea counts when it comes to fighting climate change. Let’s learn and grow together! 🌍

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

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