Credit risk frameworks need to respond to rising physical climate damage, report says

Credit risk frameworks should be overhauled to account for exposure to accelerating physical climate risk, increasing insurance inadequacy, and investment in resilience measures to respond to the crisis, a report from Cambridge University suggests. The report from the University of Cambridge Institute for Sustainability Leadership (CISL) proposes a framework that integrates these factors into core credit metrics to help financial institutions better assess and price climate risk. “The physical climate risks that are coming down the pipe are going to impact everybody and it's going to hit all economies and there is a real question of what this means for financial stability,” said Gwyn Rhodes , co-author of the report and head of the CISL’s Banking Environment Initiative. Rhodes noted that it is currently difficult for companies to justify borrowing to invest in climate adaptation and resilience measures such as flood defences because those investments will not necessarily yield more revenue even if they protect them from future climate hazards. “Typically banks would look at that and say ‘so I'm going to increase the gearing in the company, you're going to take on more debt, but you're not actually going to generate more revenue to repay the debt’. So that's quite counterintuitive from a traditional bank lending perspective,” he said. The problem is exacerbated by the fact that the international Basel framework for managing credit risk relies on data about the historic performance of similar loans, a backward looking perspective that cannot respond to the pace of climate shifts. For example, the fact that flood-related disasters have risen 134% since 2000. “It's quite difficult from a structural perspective for banks to take into account that this company is going to invest in something that will make it a better credit risk in the future but the system they are using doesn’t necessarily help them to factor that in,” Rhodes said. Insurance blind spots The current system of assessing credit risk usually assumes that physical climate risk will be covered by insurance, but that is increasingly coming into question as some assets or geographic areas become uninsurable , for example, after the wildfires in California in 2025. The report notes there is no mechanism to recognise investment in adaptation and resilience measures as a credit-positive variable, with only 36% of insurers providing explicit incentives for resilience measures and loss mitigation. “Treating insurance as given and offering no way to credit investment in adaptation leads to blind spots on bank balance sheets that could both become costly and create undesirable incentives,” said Nora Pankratz , assistant professor of finance at the University of Toronto. Pankratz noted that California regulations include insurance discounts to encourage homeowners to invest in wildfire mitigation, although the savings are too small to provide enough of an incentive. “The key takeaway: resilience investments make borrowers safer, not only more indebted,” she said. Pricing the risks and opportunities of climate adaptation The CISL framework attempts to price in not only the risks but also the opportunities from investing in adaptation and resilience. “We factor all of those things in to try and help build a business case for the banks to help lend that money to their customers to invest in resilience because over time those banks will hopefully get a lower capital allocation against those assets because it's less risky,” Rhode said. The report calls on regulators to standardise methodologies and create incentives to strengthen financial stability before losses begin to accelerate. It highlights steps some regulators are already taking to address these issues, such as the European Union ’s infrastructure supporting factor , which allows banks to reduce their risk-weighted assets when lending to infrastructure projects. It CISL report notes that the Monetary Authority of Singapore is running a capital relief pilot and the UK’s Prudential Regulatory Authority (PRA) is giving banks clearer guidelines on managing climate risk. Rhodes said banks have a range of approaches to how they address physical climate risk, which is why it would be helpful to have more standardisation and regulation on this topic. “It would also allow us to better benchmark between banks in different jurisdictions and how they compare with their peers in terms of their own resilience to physical climate risk,” he said. The report was based on collaboration with a group of banks but Rhodes said he was keen for input on the framework from other banks and regulators. The post Credit risk frameworks need to respond to rising physical climate damage, report says appeared first on Green Central Banking .