Global Landscape
Climate change is a pressing concern with the potential to significantly impact the global financial system; serving as a high priority agenda in many forums such as G20, Davos and supervisory agendas. Banking authorities around the world are actively conducting climate scenario analysis (CSA), utilizing a range of top-down and bottom-up approaches to assess climate-related financial risks.
The prevailing findings from CSA initiatives to date, indicate that under extreme climate scenarios, banks could experience a substantial decrease in profitability. This downturn stems from an anticipated rise in expected credit losses stemming from exposures directly affected by climate change, such as residential mortgages and lending to high-emitting industries. Moreover, the adverse effects of climate change could extend to the capital positions of banks, further exacerbating their financial stability.
Australia’s Journey : Understanding and Responding to Climate Risks
To understand the industry maturity in understanding and responding to climate change risks, APRA conducted a preliminary survey in mid-2018 across 38 large institutions in banking, insurance, and superannuation sectors, with results published in March 2019. In response, the cross-industry prudential practice guide, CPG 229 Climate Change Financial Risks, was issued in November 2021.
The inaugural climate risk self-assessment survey in March 2022 assessed alignment of Tier 1 to Tier 2 medium-to-large APRA regulated institutions with the guidance’s expectations. Notably, many institutions focused predominantly on short-term (1-5 year) climate risks, potentially neglecting medium- and long-term impacts. Additionally, 22% of institutions expressed uncertainty about their vulnerability to physical and transition risks.
Signs of Progress: Institutions Embrace Climate Risk Management
Despite the challenges faced, the survey also highlighted positive developments. 72% of institutions reported undertaking climate-related scenario analysis, a crucial tool for understanding potential future impacts. Additionally, institutions are taking concrete steps to manage their climate-related financial risks. Examples include:
- Investing in capabilities to manage climate risks, including data and modelling.
- Integrating climate risk into governance frameworks, risk appetite assessments, and policies.
- Adjusting product offerings and portfolio mixes to reflect climate risk considerations.
- Engaging customers and investees to support a sustainable transition.
- Reducing emissions in direct operations.
In April 2024, APRA announced plans to initiate a second self-assessment survey, with many questions remaining unchanged. This will facilitate a standardized evaluation of approaches and track entities’ evolution over time.
Weathering the Storm: How One Institution is Building Resilience to Climate Risks
The financial sector is undergoing a crucial shift. Traditional stress testing frameworks, once focused solely on economic factors, are evolving to incorporate climate risks. This use case explores how NixoraGroup supported in augmenting a bank’s existing framework with climate scenario analysis (CSA). This adaptation reflects a growing recognition within the financial sector of the need to incorporate climate-related factors into risk assessments.
Challenges of Integrating Climate Data
While traditional stress tests and CSA share core components, the bank encountered unique challenges when adapting the framework for climate scenarios. A key difference lies in the data itself.
For example, climate scenario data typically covers a much longer time horizon compared to traditional scenarios. To capture the expected materialization of risks within this extended timeframe, the data needed to be pre-processed.
Preprocessing for Seamless Integration
To integrate the data, normalization and interpolation techniques were applied to the data. his ensured seamless alignment with the existing stress testing framework, guaranteeing consistent data comparisons.
A Unified View
In a step to innovate and streamline the process; a custom-built application was developed. This application embedded both the climate scenario data and traditional macroeconomic scenarios, providing a single, unified view of their combined impact.
The application offered several noteworthy features:
- Granular Analysis:
Users could scrutinize the impacts at both individual firm and aggregated levels, drawing insights from pooled variables.
- User-Driven Scenario Weighting:
This feature allowed for a more nuanced understanding of potential risks by enabling users to weight different scenarios based on their perceived likelihood.
Benefits of Enhanced Analysis
Through this comprehensive analysis, the bank can gain a deeper understanding of how climate and macroeconomic scenarios could affect individual entities and broader market trends, aiding informed decision-making and proactive integrated risk management strategies.
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