Industry
Banking
Banking Services Transformation: Unlocking Exponential Value
Solution
Sustainability Services
Ecosystem-led Approach to Power Your Sustainability Strategy
Highlights
- Regulators continue to push for integration of ESG and climate risk into a bank’s underwriting and credit assessment function.
- Majority of the large banks started with a combination of questionnaire (qualitative) and external data for establishing a climate risk rating at a counterparty level before integrating the same in credit risk.
- However, increasingly banks are looking to leverage the disclosures from counterparties and other established government agencies to establish an internal data and model ecosystem for evaluation of climate risk and integrating the same.
On this page
Evolving Climate and ESG Regulations
Financial Institutions (FIs) and banks operate in multiple jurisdictions wherein a lot of the activities of their customers and clients or their businesses are exposed to the negative effects of climate change.
As a result, multiple regulators are pushing banks to integrate climate and ESG risks into their credit risk assessment and underwriting practices.
Figure 1: Existing Climate Risk Framework
- Varying degrees of integration: None of the banks across geographies have completely integrated climate risk in their credit and underwriting functions. While large banks have initiated exercises to onboard climate risk factors into the assessment, smaller and mid-size regional banks are still planning the same
- Use of qualitative approaches: Due to existing methodological constraints related to modeling methodologies, availability of key risk indicators (climate), etc., banks continue to rely on qualitative adjustments and survey questions for ascertaining climate risk rating
- Inconsistent information from relationship managers: One of the major information sources in qualitative approaches is the feedback from the relationship managers. However, banks do not have any consistent way to keep track of this information from transparency and auditability perspectives
- Lack of internal data and reliance on vendor provided indicators: Banks currently do not have a framework to capture relevant ESG data from various counterparties for evaluation. As a result, reliance is on vendor provided data which is inconsistent and not reliable at times
- Lack of quantitative approaches: Banks have struggled to onboard strong analytical and quantitative approaches due to lack of consistent data across customers and industries.
The Way Forward
For effective climate risk evaluation, banks need to revisit their internal climate specific data collection and management platform
Banks have taken an approach of qualitative adjustments to credit risk ratings basis external data and survey questions. However, the same is not sustainable considering the credit exposure and regulatory focus.
To manage climate risk for corporate credit, banks will need to move to a more client-centric approach wherein data is collected through customer (instead of only vendor provided data sets) and mapped to a climate specific data model and processed via advanced quantitative models for benchmarking and ratings purposes.
This is like the existing underwriting process from a financial standpoint wherein though there are multiple data and ratings providers for corporates, banks still collect required financial data directly from customers. This is to maintain required transparency and control over the data.
In our view, below are some of the key initiatives wherein banks will need to invest from a climate credit integration perspective:
- Framework to facilitate climate data collection: Across the globe companies have started adopting climate and ESG disclosures as part of their annual or quarterly public disclosures in the form of Task Force on Climate-Related Financial Disclosures (TCFD), Board, Sustainability or other reports. Banks need to set up a framework to collect this data consistently both for historical and going forward basis
- Climate specific data catalogue: To standardize the information collected across corporates, banks need to create an internal climate data catalogue that would help standardize the data collection and make the benchmarking and comparison relevant across the customers / industries. This can be something like financial spreading in underwriting process wherein different types of customer financials are mapped to standardized templates
- Transparency and data gaps: Banks also need to do an internal assessment to understand the data gaps as well as methodology for risk ranking from a climate perspective. Considering the regulatory and governance focus, banks also need to focus on auditability and repeatability of the said process
- Climate specific metrics: Banks need to undertake a study to understand various disclosures across different customers and industries and create a comprehensive set of metrics and pre-built reports and insights.
Key Design Elements for a Comprehensive Solution
Considering the focus areas, there are key design elements required to implement the above capabilities.
These capabilities can be divided into following main categories:
- Data Collection, Aggregation & Ingestion: Ability to read various disclosures and capture data automatically into the customized climate data model. These would primarily include capabilities related to web scrapping, OCR, NLP based data mapping, customized data model, etc.
- Analytical Engine: A set of quantitative models to calculate risk rating basis the reported data and external factors related to transition and physical risks
MIS Dashboards and Risk Metrics: Comprehensive set of metrics basis industry, portfolio and geography exposure.
Figure 2: Recommended Climate Risk Framework
Conclusion
Establishing a climate data collection framework and adopting quantitative approach is a long-term solution.
While doing so banks need to assess their existing data needs and enhancements that are required within their internal risk rating and reporting processes from a climate credit integration perspective. This needs to be initiated with the identification of key impacted portfolios, industries and customer segments. Once identified, banks must initiate a gap assessment exercise to identify the required data and technology needs and to define the desired implementation plan. Some of the focus areas of the gap assessment should include (but not limited to) the following:
- Establish a baseline understanding of current data platforms, business, technology and data architecture, data quality and governance processes
- AS-IS assessment of operating model: people, process governance, reporting, data & analytics as well as technology landscape
- Establishing critical KRIs (key risk indicators) such as climate exposure concentration, climate risk adjusted return on capital, collateral sensitivity, etc.
Based on our experience, we also recommend some of the guiding principles to start the above exercise :
- For integration, banks can initially focus on physical risk as the data is widely available and then move to transition risk specifically for large and mid-size corporates. Mortgage and commercial real-estate portfolios can be prioritized first, considering the impact of physical risk on such portfolios and data availability
- Depending on the industry exposure, priority should be given to high-carbon intensive and ESG regulated industries. This is mainly because these industries or sectors will be the first to adopt a carbon neutral economy driven by regulatory push and public opinion
- Leveraging internal climate reporting for the board to identify the key metrics and risk indicators for identification within customer reports.
In the present context, with climate impacts becoming relevant in various aspects in the lives of individuals as well as communities, it is imperative that regulated entities on the financial sector lead by example to ensure a better medium to long term future. In our opinion, data driven insights are key for meaningful and relevant decision making given the varying and at times conflicting pull of end customer preferences, regulatory agenda, and the banks’ current strategic imperatives. However, as custodians of the financial foundation of both their clients and broader society, it is imperative that financial institutions take a strategic and comprehensive approach to managing climate credit risk.
