Risk management in times of climate change

By Thomas Lederer, Senior Manager Solution Consulting Risk Europe at Finastra

Floods, heatwaves, drought. The impact of climate change can be felt around the world for both businesses and consumers. It is forcing banks to rethink their risk management strategies to include environmental, social and governance (ESG) factors. The key difference between "traditional” and ESG risks is that the latter affect everything. They act as risk drivers for the more "traditional" types such as credit, liquidity and leverage. They also create potential risks throughout the supply chain, which means that banks need to consider these factors in every sector and company within their entire network. 

The urgency of this evolution of risk management is underlined by the increasing requirements from central banks and regulators. They expect financial institutions to identify potential risks and comply with disclosure requirements on their ESG actions, creating transparency for customers and regulators while forcing institutions to review and adapt their strategy.

A holistic approach is needed to accurately assess, disclose and mitigate such risks.  

Good preparation is key

In recent years, banks have become much more aware of the enormous importance of climate risk scenarios and stress tests. However, many financial institutions still find it difficult to integrate them concretely into existing risk management structures. Banks may be tempted to dive in without having established the foundations beforehand. 

Climate risk scenarios and stress tests are extremely complex and regulatory requirements are becoming increasingly stringent (see the United Nations Sustainable Development Goals or the EU Green Deal). Before diving into analyses and stress tests, banks must first and foremost ensure that they adequately train and regularly update their staff on how to identify and measure new types of risks. Only with highly qualified and informed staff can management be effective and efficient. Next they can then assess the status quo in terms of the potential impact of both physical risks (e.g.: drought, sea level rises or supply chain breakdown) and transition risks (e.g.: new legislation such as CO2 tax, or structural market changes in terms of increased demand of raw materials which is heightening supply chain risks).

Based on this information, and after the workforce is adequately prepared, processes then need to be created to integrate this into risk management. Most banks already have strong risk management structures in place, although ESG risks are often treated as secondary. Only within the framework of an adequate structure can the analysis results and stress tests effectively support decision-making. In this way, risk management becomes more than just a check-box activity and fulfils its overarching purpose of enabling better decisions. 

Incomplete data should not delay action

Many financial institutions will agree that the integration of ESG into banks' risk management is important, but often assume it is not feasible due to a lack of or incomplete data. In the current global situation, it is extremely challenging to predict the impact of economic or ESG risks, particularly as the past is often not indicative of future results.

There is no doubt, then, that the continued collection of data is one of the main ongoing tasks for risk management. Accurate data needs to be built up over time. However, this is not a reason to delay action now. Those who only react to new regulatory requirements are not in a position to act proactively and strategically to mitigate potential risks occurring today. Moreover, the data situation is already constantly evolving. The global pathways set by the Intergovernmental Panel on Climate Change (IPPC), for example, are a good starting point for including ESG factors in the risk management cycle. The first step is to identify the relevant risks on a case-by-case basis. ESG risks have complex cause-and-effect relationships that need to be considered in the first step of the inventory without getting too caught up with data points, or lack thereof.

Rather than relying heavily on data, then, institutions need to implement processes that make sense for their business to identify risks, followed by effective measurement and assessment. It is important to remember that ESG factors affect all known types of risk. From operational to market price and liquidity to counterparty risk. An important step here is the assessment of ESG exposure as it relates to your entire operations. How ESG risks affect the calculation of economic and regulatory capital as well as capital adequacy is the key question in this context. There is currently no one universally valid method for assessing ESG risks. Depending on the use case, specific scenario analyses and stress testing is required, which involves the interpretation of results in light of the limitations of the analysis and inherent uncertainties. We can also make assumptions about which industries within a bank’s supply chain may be hit, in light of recent scientific evidence.

Once risks are identified and assessed, both reactive and preventive control measures can be developed to manage ESG objectives. The latter include portfolio reassessment as well as reputational and operational risk management. Preventive control measures may include, for example, mandatory consideration of ESG risks in all change-the-bank processes. Then, once data is built up over time, institutions can slowly adapt their processes in accordance with analysis of that data.

Taking a holistic and collaborative approach

The challenges we face are global and cross-sectoral. ESG risks affect all departments of an institution and its entire supply chain. It follows that risk management measures must be holistic. Banks that find the right balance between detailed analysis on the one hand and a view of the bigger picture on the other will not only reduce risks but will also be able to benefit from new opportunities at the same time. So, the sooner banks start integrating ESG factors into their risk management, the better. To make this necessary transformation effective and efficient, collaboration is an essential aspect. With the help of open APIs, banks can integrate specialist solutions from various fintech companies into their current processes. In this way, financial institutions can benefit from the expertise of others and react more quickly to new requirements without having to reinvent the wheel in every niche. In short, the risk management of the future is collaborative.

The term green finance implies a simultaneity of green and non-green finance. In fact, this distinction has become obsolete. There are no longer any areas in financial services where climate change does not play a role. Green finance is not one option among many, but the only possible way!