Embedding climate risk into banks’ credit risk management
The increasing severity of natural disasters and other negative consequences of climate change have led to growing recognition of the need for collaboration to reach a sustainable solution. The Conference of the Parties (COP26), bought together parties for the United Nations Convention on Climate Change, enhancing commitment and accelerating actions towards the Paris Agreement's goal of reducing greenhouse gas emissions to zero by 2050.
On a local level, the Bank of Thailand is committed to provide continuous support for the country to achieve economic and social security across various dimensions, including environment, social, and governance, based on the principle of sustainable banking. Most recently, on December 26, 2022, the Bank of Thailand, the Securities and Exchange Commission of Thailand prepared a standard for grouping economic activities that consider the environment, 'Thailand Taxonomy', for hearing and suggestions across the government, private and public sectors. The banking sector plays an essential role in solving such problems. Accelerated collaboration between the banking sector and customers will significantly change credit management process.
The credit risk lifecycle consists of seven main steps, which will all likely be impacted by climate risks.
1. Strategy and products - Banks should introduce scoring systems or indicators that can estimate the effect of greenhouse gas emissions according to each risk perspective, such as industry or customers. These systems could also be leveraged to formulate business strategies. In addition, banks should design their products incorporating climate risks. By expanding green financing to compensate for greenhouse gas emissions, such as lower interest rates for environmentally friendly construction, this can further motivate clients' participation in reducing emissions.
2. Prospecting and origination – Ideally, banks should assess the impacts of physical and transition risks on clients’ credit risk at the onset of new relationships. The scope of assessment may depend on the industry, region, and customer. Banks should ask customers for additional information on energy consumption attributed to new business activities, supply chain information, and data on emissions per unit of revenue.
3. Underwriting and approval – Banks should infuse climate risks into the rating and underwriting process. The assessment should take the clients' physical and transition risks into account. Some banks are also creating shadow rating systems to evaluate customers' default probabilities in relation to climate alongside typical default probabilities. Then, banks can adopt mitigation effort when there is a large differential between the two approaches.
4. Collateral management and hedging – Both physical risk and transition risks can affect the collateral value, such as natural disasters that damage physical assets or cause changes in real estate values. However, banks currently have limited opportunities to transfer climate risks because the market in this regard has not yet developed. A lack of expertise and limited data on carbon intensity may make it challenging to develop a hedging strategy. Therefore, banks will likely need to develop new strategies to work counterparties to hedge climate risk. This could include opportunities to collaborate with insurance firms and other entities to design derivatives contracts for climate risk.
5. Portfolio monitoring and management – Banks must develop new methodologies to quantify climate risk at both borrower and portfolio levels. Banks will need additional data, such as emissions or strategies for managing transition risks. They should evaluate the borrower's ability to repay debt and the effect on the bank's operating costs across various scenarios. As a result, the banks can better manage the credit portfolio to cover the risks associated with climate change.
6. Default management – Banks should consider the root causes of default and asses if climate risk was a factor. For example, a technology company's inability to repay the principal could stem from the supply chain being affected by major flooding elsewhere in the world. Suppose banks fail to incorporate climate change as a root cause of late or default payments. In that case, they will likely underestimate these risks in their credit models and provide loans with lower interest rates, ultimately affecting the bank's profitability.
7. Reporting and disclosure – The Task Force on Climate-Related Financial Disclosures ("TCFD") is a standardized international reporting framework that enables companies to disclose climate-related financial information effectively. The framework requires reporting across four dimensions: governance, strategy, risk management, and metrics and targets. Banks should develop guidelines for building their TCFDs and gathering information on risks and opportunities over different time periods. Then, banks can systematically define the roles of management and boards in managing those matters.
Embedding climate risk into credit risk management is considered an essential responsibility for the bank, even though it could be an enormous undertaking for most banks. Moreover, borrowers should consider establishing guidelines for managing climate risks and provide banks with more information. These changes are necessary to fuel the transition to a carbon-neutral future.
By Narumol Jirapanich
Director | Risk Advisory - Financial Industry Risk & Regulatory