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How improved climate risk financial models can support change

Recent research suggests banks are failing to comprehend the risks posed by climate change. Read more in our latest blog.

Recent research suggests banks are failing to comprehend the risks posed by climate change. Financial models deployed to understand climate risk for large banks and financial institutions are often in response to central banks’ stress testing or broader disclosure requirements. The results could portray financial models on climate risk as being “implausible”. However, this only partially reveals the efforts happening behind the scenes.

Analysis of banks’ responses to stress tests reveals the multifaceted approach of their climate risk assessment efforts.

  1. Simplifying assumptions
    The outcome of a stress test  ̶  specified by a central bank  ̶  shouldn’t be confused with actual risks stemming from climate change. Despite the sophistication of these exercises, assumptions must be simplified to bind these models to some form of contextual reality. Real world circumstances assume that insurance availability is predictable, economic impacts follow rational paths, and if whole physical climate perils are included or excluded. For example, most stress tests are yet to input the necessary data to model mass migration risk  ̶  a feasible scenario in the future. At global banking institutions, internal debates on their emerging stress test results occur at many levels and can be conducted with great candour, with potential missed risks or improved modelling consistently analysed. The gap between their narrative and that of the Intergovernmental Panel on Climate Change is keenly felt. Financial institutions are aware their modelled results are not yielding data they would expect to reflect the urgency and magnitude of the impacts of climate change. Even though internally this is a source of discomfort, banks cannot alter the parameters of stress tests and subsequently void the value of peer comparison for the regulator.
  2. First-order effects
    Of risks highlighted within exercises themselves, only first-order effects are routinely accounted for. For example, the direct physical risk to a mortgaged property  ̶  while crucial  ̶  may be less impactful to its value than the fate of local employers sustaining the town’s economic viability. Novel, holistic methods are emerging to treat this. However, these were unavailable at the time of, for example, the Bank of England’s ground breaking 2021 Climate Biennial Exploratory Scenario exercise, and so were a known limitation of this exercise and others.
  3. A foundation to build on
    Until several years ago, banks were entirely unfamiliar with the concept of adding climate risk data to credit models. However, today this notion is commonplace. Foundational activity should not be trivialised as it forms the underpinning of more complete and sophisticated climate impact assessments.

Ultimately, basing differentiated lending decisions on these models is where they will help mitigate the calamitous future possible without rapid decarbonisation. No bank wants to be the final lender for a risky asset. Consequently, an arms race is emerging among banks to build out these models  ̶   beyond any regulatory requirements. The wider public stance has, quite rightly, been framed around ownership and causality of climate change. However, it is through improved lending decisions that banks will enact meaningful change within their sphere of control.

While current climate risk financial models are widely considered as still imperfect, sustained efforts are transforming them into an invaluable tool for fighting climate change through economic means.  Significant progress in this area will help risk managers everywhere better account for climate risk impacts and improve their business resilience strategies for what lies ahead.