What can global banks learn from local banks in terms of physical risk assessments?
Local banks are increasingly focusing on the physical risks associated with climate change, particularly in their residential mortgage and agribusiness loan portfolios, according to Will Farrell (pictured above), associate at EOS, Federated Hermes’ stewardship arm.
As extreme weather events like wildfires and flash floods become more frequent, Farrell noted that these risks are starting to pose significant challenges for financial institutions.
“Until recently, investor engagement with banks has tended to focus on the role that they can play in financing the low carbon transition and managing the banks’ transition risk exposure,” he said. “But as extreme weather events become more frequent, physical climate risks are intensifying on bank balance sheets.
“With a high-emitting commercial client, like a steel plant or an oil producer, the risk is concentrated in fewer identifiable physical places, but banks face a different challenge in their residential mortgage and agribusiness loan books.”
Farrell cited a 2023 study by Bain & Company and Jupiter Intelligence, highlighting the potential impact of climate risks on banks.
The study, which modelled an Italian bank portfolio, found that without mitigating actions, the value of mortgage collateral could decrease by as much as 10 to 15% by 2050, reducing mortgage lending profitability by seven to 10%.
Farrell, who engages in dialogue with company executives on climate change issues across the sectors of financial services, energy, chemicals, and materials, pointed out that local banks may have an advantage in addressing these risks due to their proximity and familiarity with the specific challenges in their regions.
“For example, Commonwealth Bank of Australia (CBA) maps three material risks to its domestic home loan portfolio: cyclones, wildfires, and flooding,” he said.
“CBA deems 4.6% of its home loan collateral to be at high risk of physical climate damages, while HSBC UK estimates that 3.5% of its retail mortgage portfolio is at high risk of flooding, and 0.2% is at a very high risk.
“Australia’s third largest bank, National Australia Bank is even formalising credit score-like tools for assessing individual home and farm physical risk exposure.”
Farrell added that agribusiness loans present additional challenges due to the evolving nature of physical risks over time. He said the resilience of agricultural assets often depends on the health of local ecosystems, which can change due to deforestation or other environmental factors.
To address this, CBA is encouraging its agricultural customers to adopt regenerative practices and offers sustainable financing products to support these efforts. These products, which include discounted green agricultural loans, are designed to help farmers restore natural capital, improve yields, and build resilience to climate risks.
As local banks continue to integrate physical risk assessments into their operations, Farrell suggested global banks may need to follow suit.
“EOS is asking globally diversified banks to develop the capabilities to capture and integrate customer-specific physical risk exposures into day-to-day banking,” he said.
“However, there is a significant data and resource challenge for large and highly diversified banks. Banks and their shareholders must appreciate the local and nature-dependent dynamic of physical risk exposures, the pricing of which will enhance know-your-customer procedures.
“Ultimately, the efficient pricing of bank loans through this physical risk lens will become increasingly important if banks are to manage their capital allocation in line with their stated risk-reward appetite.
“This integrated climate risk management mechanism will also play a broader and essential economic role in providing financial incentives to customers to invest in adaptation efforts, including through restoring and preserving nature and biodiversity.”
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