Banks and Climate Change Risk

Banks as financial intermediaries are broadly exposed to a wide range of economic and financial risk factors. We parse climate risk into its two main types: physical risk such as sea level rise and transition risk such as climate related policy changes (e.g., efficiency requirements or carbon taxes), technological innovations (e.g., improved solar and battery efficiency) and changing customer preferences (e.g., embracing electric cars). We discuss the wide range of exposure channels through which climate related risks can impact banks’ risk profiles with particular attention to credit risk, the dominant risk for banks. Climate change can lead to an increase in storms, flooding, mudslides and wildfires which, in turn, can subsequently impact property values and defaults, posing increased credit risk. Mandates of increased energy efficiency in office and apartment buildings could results in costly upgrades. We point out that it is critical to account for the significant heterogeneity within (and certainly across) sectors in their sensitivity (sign and magnitude) to climate change to properly characterize the risks (and rewards). We explore and illustrate these points with three examples, two for transition risks, one for physical risk. We cover climate scenarios and stress testing as well as relevant development in bank supervision.