Why Predicting Climate Impact Is a Daunting Task for Banks

Last week, we discussed how weather-related events are affecting the insurance market—and the impact for banks. That’s among several significant challenges banks face in predicting the impact of climate change on their loan portfolios, according to the Federal Reserve’s first analysis on the issue. 

We reached out to Canesha Edwards, RMA’s climate and model risk program manager, for her insights on the Fed’s findings. 

How does climate risk become financial risk? 

EDWARDS: One way concerns climate risk’s physical aspects—for example, a storm that destroys bank collateral. Another way is through what’s known as transition risk. An example of that is the possibility that climate-related regulations or market movements change the prospects and profitability of business borrowers and make them riskier. The Fed exercise focused on how such climate risk drivers could translate to credit, market, operational, and liquidity risks. With respect to physical risk, the analysis found that U.S. financial institutions are heavily exposed: In aggregate, 20% of commercial real estate portfolios and 50% of residential real estate portfolios would be impacted by a 1-in-200-year hurricane making landfall in the Northeast. 

What are the challenges with managing climate risk? 

The exercise revealed an absence of internal data, climate models, and frameworks banks could use to evaluate key climate risk exposure factors including the resilience of financed buildings, insurance coverage for collateral, and borrowers’ transition risk management capabilities. Instead, participants tended to use existing credit models with adjusted inputs to capture climate-related risk, or they heavily relied on third-party vendors. Another notable challenge is determining how to incorporate climate risk into standard risk management practices, given the uncertainty around the timing of climate events and the ability to quantify damages. 

What does the future look like for climate risk management? 

It’s an evolving practice that will require institutions to continue investing in their internal capabilities related to modeling, including design, data, and assessment. In addition, we need a better understanding of the indirect impacts of climate risk, such as disruptions to local economies. According to the Fed study, climate risk analysis has not yet reached a point where it is useful for decision making. To get there, institutions need access to more granular data that is asset-, sector-, and industry-specific. 

For more on topics like this, visit RMA’s Climate Risk Consortium.