Climate risk can weigh on banks’ credit fundamentals in several ways. As a result, central banks and supervisors are increasingly acknowledging that climate-related risks are relevant for financial stability and the soundness of banks.
Climate change impacts not only the environment: adds risk for financial markets
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Climate change can impact banks’ credit fundamentals through heightened risk in loan and asset portfolios; and potentially via higher funding costs and capital requirements. This impact is overviewed in the latest Scope Ratings report.

Financial risks related to climate change can arise primarily in two ways: physical risks from the increased severity and frequency of climate and weather-related events damaging property and impairing the creditworthiness of borrowers. And transition risks arising from the adjustment to a lower-carbon economy, with changes in policies, customer preferences and technologies potentially leading to a reassessment of the value of assets and companies.

“Banks do not currently provide enough detailed and consistent information for us to systematically incorporate climate-related risks into our rating approach,” said Pauline Lambert, executive director in the financial institutions team of Scope Ratings and author of a report on ESG. “However, as disclosures improve, and supervisory assessments become a reality (in particular, stress tests) we see climate-related risks becoming a more tangible part of the credit process.”

There are growing demands from investors for banks to improve their disclosures on climate-related risks. While still insufficient, an increasing number disclose information on their boards’ oversight of climate-related issues and the integration of related risks and opportunities in their risk management processes. For those banks unable or unwilling to disclose the information the market increasingly wants, funding costs could rise. As ESG factors become a consideration in more and more investment mandates, banks that rank poorly are likely to face diminished investor support.

“Although the time horizon for transitioning to a low-carbon economy is long compared to the more short-term nature of corporate loans, banks still need time to adapt the exposures and risk profiles of their loan portfolios,” Lambert continued. “This is not straightforward, however, as there is still limited information on how specific climate-transition scenarios may impact the creditworthiness of specific borrowers and industries.”

Meanwhile, the lack of climate-related financial regulation is not preventing central banks and supervisors from acting.

As part of its stress test of the UK financial system in 2021, the Bank of England will assess the resilience of UK banks to the physical and transition risks of climate change.

The Dutch central bank already integrates climate-related risks into its supervision of banks and insurance companies.

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