Project launched to test lending portfolios for environmental risk

A syndicate of banks and academics has launched a joint project to pilot scenario modelling to stress-test corporate lending portfolios for environmental risk. Citi, UBS, ICBC, Banamex, Banorte, Caixa Econômica Federal, Itaú Santander and FIRA have teamed up with the Natural Capital Declaration and the German Government’s Emerging Markets Dialogue on Green Finance to include the economic impact of drought in bank stress testing scenarios. In a first step, the pilot project will develop an analytical framework to enable bank stress testing models to include scenarios of the economic resilience of major industries to the risk of extreme droughts.

Liselotte Arni, head environmental and social risk at UBS, said that while climate change is a global phenomenon, its impacts will vary across geographies. “This project will explore unchartered territory by accounting for local variations when stress testing the impact of drought scenarios on credit quality indicators in different industries and regions," she commented.

The nine international financial institutions -- representing more than US$10trn in assets -- will input into and test the analytical framework to ensure the development of a systematic shared approach for banks to assess their financial exposure to extreme droughts through corporate loans.

The project team has appointed global catastrophe modelling firm RMS, which will work with European academics and global research centres to develop a drought model to enable financial institutions to better understand their exposure to environmental risk, and will develop scenarios for five countries – Brazil, Mexico, China, India and the US.

Managing director of the firm, Daniel Stander, said this ground-breaking project is further evidence that catastrophe modelling techniques have application far beyond the industry that pioneered them. “This project has the potential to protect the GDP@Risk resulting from financial institutions’ exposure to environmental risks. It could equally stimulate corporations around the world to take an increasingly sustainable approach to their business operations.”

Yannick Motz, who manages the Emerging Markets Dialogue on Green Finance at GIZ, says developing environmental stress testing will help to ensure the stability of our financial systems and provide the basis for financial institutions to develop portfolio strategies that “reflect the challenges of adapting to climate change and environmental degradation, whilst also supporting a transition to sustainable economic development”.

It is hoped the project will help banks test their resilience to increasing financial risks from environmental conditions that can be an ‘invisible’ drag on economic growth in the real economy.

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