Stress Testing Credit Portfolios for Climate Risk

Climate risk refers to the potential for adverse economic consequences resulting from climate change as well as human responses to climate change and is rapidly becoming one of the emerging risk areas within the financial services industry. According to the Basel Committee on Banking Supervision (BCBS), climate risk has the potential to affect the safety and soundness of individual banks and have adverse implications on the financial stability of the broader banking system.

At a systemic level, climate risk may cause widespread asset devaluation and defaults, particularly in vulnerable sectors like real estate and energy. For individual banks, climate risk drivers may impact their conventional financial risks directly or indirectly through their counterparties or financial assets.

Specifically in terms of banks’ credit risk, climate risk can deter their borrowers’ creditworthiness through operational and supply-chain disruptions and can adversely impact collateral valuations, translating to a tangible impact on the banks’ credit risk profiles. Banks and financial institutions conduct periodic stress testing of their credit portfolios to assess vulnerabilities arising from the potential impact of severe but plausible economic or financial scenarios. The interplay of credit and climate risks brings into focus a range of climate-related pathways that banks need to consider as part of the periodic stress testing of their credit portfolios.

Our latest publication ‘Stress Testing Credit Portfolios for Climate Risk’ paper explores a structured framework for banks to test the resilience of their credit portfolios to climate risk and assess its impact on their capital positions and expected credit losses under different climate scenarios of extreme severities.