Why banks’ credit risk models are blind to climate shocks

 

Rémy Estran-Fraioli is the CEO of Scientific Climate Ratings and chair of the European Association of Credit Rating Agencies; Frédéric Ducoulombier is programme director for climate regulation and policies at EDHEC Climate Institute, and a member of the Strategic Orientation Committee of Scientific Climate Ratings

Banks are still flying blind on climate risk — and regulators are partly to blame.

A recent global survey by UNEP FI and Global Credit Data found that only 18 per cent of banks integrate climate risk into their internal ratings-based models, which drive regulatory capital requirements. The study cites data gaps and methodological hurdles but does not explain the deeper problem: credit risk and climate risk models are built on fundamentally different logics.

Unless supervisors adapt, the IRB models of today will remain blind to one of the most significant credit risk drivers of this century. (...)

Integrating research such as that of EDHEC climate finance professor Riccardo Rebonato on “How to Assign Probabilities to Climate Scenarios” help transform scenario narratives from “what if” to “what is likely”, or in other words from stress testing to expected value assessments in line with IRB models’ philosophy.

Further, return period analyses could inform scorecards. For example, if we assume that a once-a-century flood damages an infrastructure asset and prevents the project company operating it from servicing its debt (despite insurance, guarantees, or government support), then its default probability should be floored at 1 per cent.

Portfolios could also be segmented not only by sector but by geography, ensuring location-specific climate hazards become visible. (...)