Stress Testing Credit Portfolios for Climate Risk

Climate risk in finance refers to the economic challenges posed by climate change and the responses to it. This type of risk can significantly affect both systemic and individual levels within the financial industry.

Systemic Impact of Climate Risk

At a broader level, climate risk can lead to:

• Asset Devaluation and Defaults: Sectors highly susceptible to climate change, like real estate and energy, may see significant devaluation and defaults.
• Financial Stability Concerns: These disruptions can result in liquidity shortages, increased market volatility, and credit losses. Due to the interconnected nature of financial institutions, these risks could cascade, potentially impacting the stability of the entire banking system.

Climate Risk at the Individual Bank Level

For banks specifically, climate risk can manifest in several ways:

• Direct and Indirect Financial Risks: Climate-related drivers may affect banks' financial health directly or indirectly through their counterparties or assets.
• Impact on Creditworthiness: Climate disruptions, such as operational or supply-chain issues, can lower borrowers' ability to repay, affecting credit risk.
• Collateral Valuation: Adverse climate impacts can devalue collateral, worsening banks' credit risk profiles.

Stress Testing for Climate-Related Credit Risks

The intersection of credit and climate risks emphasises the need for banks to:

• Identify Climate-Related Risk Pathways: Banks must consider climate factors in stress testing their credit portfolios to ensure resilience.
• Assess Portfolio Resilience: A structured framework allows banks to evaluate how climate risks might impact their capital positions and expected credit losses under various climate scenarios.

Enhancing Stress Testing Frameworks

This paper introduces a framework for integrating climate risks into existing stress testing methods. By accounting for the complexities of climate risk, banks can more accurately assess their exposure and build a more resilient financial foundation.