This article is also available in Italian / Questo articolo è disponibile anche in italiano
Floods, fires, and other extreme events: the climate crisis is not only an emergency for people and ecosystems but also a genuine threat to the stability of the financial sector and banks. The financial system is intricately linked to the real economy, making it vulnerable to the effects of natural disasters. Furthermore, its role as an intermediary makes it a potential amplifier of climate shocks, thereby contributing to spreading their impact on a global scale. To mitigate these risks, banks must reassess their strategies, prioritising loan diversification and incorporating climate factors into their risk assessments. Renewable Matter spoke with Rong Ding, Full Professor of accounting at NEOMA Business School, who explored how banks can safeguard themselves against climate impacts in a study published in the European Journal of Finance.
What was the main motivation behind this study? What led you to explore the link between climate crises and banking stability?
According to the World Economic Forum in 2023, “failure of adaptation to climate change, managing natural disasters and extreme weather events are among the most serious global risks over the next decade.” However, a major challenge both climate finance researchers and practitioners are confronting is the lack of methodologies that facilitate robust measurement of climate risk and promote a successful assessment of the impact of climate change on the stability of financial markets. The main purpose of our research is to develop a method to calibrate the climate risk banks are exposed to through cross-state lending in the U.S. Regulators are paying close attention to the influence of climate risk on financial stability. For example, in November 2017, the Economic and Monetary Affairs Committee (EMAC) of the European Parliament issued a proposal that would amend the European Union’s Capital Requirements Regulation to make climate risk management and disclosures mandatory. In July 2021, the Financial Stability Board (FSB) drew up a roadmap for addressing climate-related financial risks, which highlights four key interconnected blocks, namely disclosures, data, vulnerabilities analysis, and regulatory practices and tools. In this research, we would like to provide empirical evidence on the impact of climate risk on financial stability to inform policymakers and regulators in future decision-making.
What role do financial instruments like syndicated loans play in spreading climate-related financial risks?
Our study suggests that climate risk is transferred from non-financial firms. to banks partially through syndicated loans, which are a significant source of corporate finance for industrial firms in the US and other countries. Climate risk can weaken borrowers’ profitability and financial health. For example, a study from Pankratz et al. of 2023 shows that firms with higher exposure to climate change (i.e., extremely high temperatures) experience reduced revenues and operating income. Ai and Gao in 2022 document a positive association between firms’ exposure to climate risk events and systematic as well as idiosyncratic volatility, interpreting this as evidence that physical climate risk is somewhat unpredictable and undiversifiable. As a result, climate risk will negatively affect the ability of non-financial firms to repay the interests or even principals of their borrowing. Consequently, banks may experience a substantial increase in nonperforming loans and, at the extreme, instances of loan default, which undermines financial stability.
How was the climate risk index developed, and how could its integration into financial assessments serve as a key strategic lever?
Our approach to measuring climate risk is informed by the methodology developed by the Bank for International Settlements in 2021, which involves scoring climate risk on the basis of accounting for portfolio and sectoral exposures. The measurement of climate risk comprises two major steps: we first create a state-level climate risk index (which quantifies the extent to which states have suffered unexpected losses associated with extreme weather events such as storms, floods, heat waves etc), and then compute bank-level climate risk exposure by weighting bank lending to a state with the state-level climate risk index of the borrower’s state. This approach can be smoothly integrated into the risk assessment system of US banks because they are able to calculate their business exposure to climate risk based on publicly available data and their operational data.
How can banks protect themselves from climate impacts in the future?
Our findings highlight the importance of incorporating granular climate risk data into banks’ risk management practices and loan assessment processes. Banks may voluntarily disclose their climate risk exposure in annual reports to reduce information asymmetry. Given the notable impact of physical climate risk on financial stability, banks may work with policymakers to design climate risk-related capital buffers or adjustments to Tier 1 capital ratio requirements. These measures could encourage banks to adopt more prudent lending practices and maintain adequate capital to absorb potential losses arising from climate shocks.
What were the most surprising findings of your research? Was there any data that particularly stood out to you?
In this study, we find that unexpected climate risk exposure acquired through cross-state lending increases banks’ individual and systemic risks. In fact, we are a little surprised by the magnitude of the effect: an increase by one standard deviation in the bank-level climate risk measure leads to an increase of 14.7% in the marginal expected shortfall, 1.3% in the long-run marginal expected shortfall, 5.9% in value at risk at a 5% confidence level, 10.2% in value at risk at 1%, 2.7% in systemic risk contribution at 5%, and 6.1% in systemic risk contribution at 1%. We also find that banks reduce lending and increase loan loss reserves subsequent to the experience of an unexpected climate shock. There were no data that stood out.
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