Reviewing changes within climate risk and inclusion within risk management practices and stress testing

Rocco Fanciullo, Head of Liquidity Risk Management, UniCredit SpA

Below is an insight into what can be expected from Rocco’s session at Risk Evolve 2024.

The views and opinions expressed in this article are those of the thought leader as an individual, and are not attributed to CeFPro or any particular organization.

In what ways have you seen climate risk be included within risk management practices and stress testing?

The inclusion of climate risk within risk management practices and stress testing has followed the same path that was typically followed for other risks that institutions have encountered in the past. This path includes a risk identification phase, a materiality analysis, robust data lineage and measurement design, monitoring process definition, and a mitigation system.

Considering the importance that such risk has for the institution, this had an impact on the bank organization: specific functions have been created in the Group with the aim of steering the definition and implementation of the Group’s ESG strategy and ensuring that the ESG framework is consistent with the Group’s principles and Purpose and with relevant international standards and practices.

As far as risk management in particular:

  • New policies and procedures were designed to incorporate the new strategy requirements.
  • Specific scores on physical and transitional risk of customers’ exposure to climate are collected.
  • Internal risk management reports were enriched with measures of climate risk exposures.
  • Some of these measures were integrated into the risk appetite framework with specific limitations.
  • Specific stress test scenarios have been designed to assess the potential bank vulnerabilities to climate risk factors.
How can financial institutions ensure that they are effectively identifying potential liquidity vulnerabilities linked to climate-related shocks?

As clarified in the previous question each institution should perform a thorough risk identification analysis to identify the potential transmission channels of climate risk factors on their liquidity buffers or cash flow profile.

Once the transmission channels have been identified, each one of them has to be analyzed to assess the potential liquidity impacts that a climate scenario might have on the bank’s liquidity profile.

Climate risk could cause material net cash outflows or depletion of liquidity, mainly stemming from the financial impact on the held assets of a changing climate (i.e., physical risk) or the institution’s financial loss that can result, directly or indirectly, from the process of adjustment towards a lower-carbon and more environmentally sustainable economy (i.e., transition risk). According to the definition of physical and transitional risk, the transmission of climate risk to liquidity comes through the following channels:

  • Counterbalancing Capacity (CBC): risk premia on securities of carbon-intensive issuers (transitional risk) or issuers particularly exposed to extreme climate events (physical risk) could increase, deteriorating the market value of the liquidity buffer.
  • Deposits: withdrawals of deposits mainly due to high liquidity needs and credit losses that could stem from corporate clients with high CO2 emissions, which could have to adapt their technologies and production plants to more carbon-neutral economies (transitional risk) or from customers hit by severe weather events (physical risk), which reduce profitability and potentially increase credit risk and liquidity needs.
  • Undrawn credit and liquidity facilities: whose usage might increase for the same reasons listed for deposits.
  • Market valuation changes on derivatives transactions: climate-related price shocks and increased market volatility may result in increased derivative exposures and related margin calls.
  • Direct and indirect impacts on capital: potential depreciation in the value of assets (loan or securities portfolio) impacts the capital, which is one of the main sources of structural funding.

Each institution must make sure to properly assess the risk exposure of its customers and the impact that such exposure might have on short-term and structural liquidity.

Additionally, the transition risk appears also if the institution itself fails to adapt its practices to the new climate regulations, thus leading to reputational impacts, which would push the bank into a typical name crisis liquidity risk scenario.

Why should financial institutions look to incorporate climate considerations into their liabilities profile?

The main intuitive impact of climate risk on banks is on the loan portfolio. The probability of default (PD) and loss given default (LGD) of exposures of customers exposed to extreme climate events might increase, also through the reduced valuation of collaterals (physical channel). Similarly, the adaptation to new productive and efficiency standards may increase production costs and reduce corporate profitability, which may lead to a higher PD.

The complexity of the analysis required to estimate the risks on the assets side might divert the attention towards the impact that the climate risk strategies might have on the source of funding of the bank: customers that are highly exposed to climate risk might reduce the stable component of their deposit base. Additionally, net zero emission strategy might put banks in a position to give up a portion of their deposit base.

The attention to the liabilities profile is a key factor to make a climate strategy consistent.

Why is it important for financial institutions to integrate climate-related information into their frameworks?

Banks are usually amplifiers of the trends occurring in the real economy. Transitioning to a low-carbon and more circular economy entails both risks and opportunities for the economy and financial institutions, while physical damage caused by climate change and environmental degradation can have a significant impact on the real economy and the financial system.

In addition to this, banks’ compliance with ESG requirements is a regulatory requirement, and the failure to integrate climate-related information into the framework might produce unpleasant actions from supervisors (findings, penalties, etc.).

For liquidity management in particular, banks should carefully follow the potential changes in the collateral framework (as anticipated by one member of the ECB executive Board), which could have material impacts on the quality of the liquidity buffer.

How do you believe climate risk will develop within risk frameworks over the next 5 years?

Banks are starting to develop their internal methodologies to measure, monitor, and mitigate climate risks. This process is at an early stage, and it is set to strengthen going forward either through the normal interaction with the business and due to the scrutiny and subsequent corrections required by internal and external auditors.

Content-wise, an area that will surely require a great focus is the consistency in a risk appetite framework perspective: the introduction of climate risk KPIs in the RAF has to be consistent with the other risk thresholds already embedded in the framework.

Process-wise, one area that requires significant effort is data integration and quality.

The first front is the consistency of climate KPIs among different providers. Customers’ exposure to climate risk is currently assessed by means of internal measurements and external providers’ KPIs, which are often not homogeneous among one another, both in the taxonomy and in the content.

Another area is to manage inconsistent messages arising from climate risk scores and environmental risk scores: as a matter of fact, a company might rank well in terms of climate score but not as well in the environmental perspective.

Finally, an important bulk of new data needs to be properly integrated into the bank’s systems in order to be elaborated in the risk monitoring tools.