Physical climate risk to major US banks over $250 billion annually: Ceres

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Research from Ceres, the non-profit focused on sustainability challenges such as global climate change and water scarcity and their implications, has found that major US banks have more than $250 billion of exposure to physical climate risks annually sitting in their loan portfolios.

climate-change-risk-imageIn fact, the research found that of $2.2 trillion of syndicated loan exposure analysed, more than 11% is exposed to physical climate risk.

Two-thirds of that risk is related to the indirect economic impacts of climate change, such as supply chain disruptions and lower productivity.

With the majority of that exposure being linked to coastal flooding, from sea level rise and also the impact of larger hurricanes.

The climate risk related exposure US banks face is actually larger than their exposure to subprime mortgage, which gives an idea of the scale of the challenge that will be faced as climate related risks appear more amplified by rising exposures and evolving frequency and severity trends.

To undertake the research, Ceres worked with consultants from CLIMAFIN, using natural catastrophe and credit risk models that had been adjusted for climate effects, as well as macro-economic data, and publicly available syndicated loan information for major U.S. banks.

“While the industry has taken steps to mitigate climate change risks, the enormity of these threats means banks and bank regulators still have much work to do,” Dan Saccardi, senior director of the Ceres Company Network at Ceres commented. “The sector must stop treating the climate crisis as a reputational risk with minimal financial implications and instead reconsider how today’s financing activities, risk management, and strategic planning can help banks minimize economic instability and disruption in the long-term – for themselves, the economy, and broader society.”

“The risk uncovered by Ceres’ report is significant, but it’s only a piece of the puzzle: We examined syndicated loans because public data is abundantly available, but this represents only a fraction of banks’ portfolios,” added Steven Rothstein, managing director of the Ceres Accelerator for Sustainable Capital Markets. “And, physical risk has potential implications for other asset classes, which is why more work is needed by banks to develop holistic understanding of the risk that exists within their respective portfolios. With the right strategic approach, addressing physical risk can lead to opportunities in adaptation finance, and the banks that lead in this work can create significant new value for their institutions, clients, and the broader economy.”

“Considering the uncertainty that climate change introduces regarding the trend in intensity and frequency of weather events, banks are dedicating resources to understand the impact of different climate scenarios and how those translate into financial risk measures,” Martha Raber, executive vice president/managing director and head of financial risk activities for Regions Bank also said of the research. “Financial institutions are contemplating climate risk disclosures and the use of firm-level data to better understand physical climate risk’s materiality to their operations and their clients.”

The research output calls on banks to assess and measure their climate risk exposure, take actions such as ensuring it is priced for, learn to understand the changing insurance marketplace and opportunities in risk transfer, while also focusing on adaptation and mitigation.

So, why is this all important. Ceres sums it up well.

“There is no longer anything atypical about the intensity or frequency of climate-induced disasters. They will continue increasing in a nonlinear fashion, and the resulting economic and financial impacts will not be short term. Entire areas will become uninsurable and assets will face revaluation; banks will see both a higher probability of loan defaults, and higher losses in the event of default,” Ceres explains.

They also note that, “While insurance can mitigate some direct risk, this only spreads out the costs across the financial system. This risk will come back around to affect banks in several ways, including increased cost of in- surance for clients, lower property values, and an increasing number of uninsured assets that ultimately increase default probabilities and therefore increase non-performing loans and potential risk.”

Which is very true, insurance and reinsurance is not a fix for climate risk, but it is a very important financial risk management tool that these banks should really be utilising to hedge against the negative effects physical climate risks could have on their loan portfolios.

It’s also interesting to consider that with the climate value-at-risk to 28 of the largest U.S. banks from physical risk likely more than $250 billion, how high would that figure be if you included other physical natural peril risks, such as earthquakes.

So, it’s abundantly clear that banks in the US, by which you can also read across to banks around the rest of the world, are carrying enormous amounts of physical risk to weather, climate and catastrophe in their loan portfolios and also in their balance-sheets.

We’ve already seen some examples of financial institutions and investors reacting to natural catastrophe risks that are embedded in their portfolios of assets, such as loans and real estate.

Examples of relevance to the insurance-linked securities (ILS) community are the Wrigley Re catastrophe bond, issued to the benefit of a real estate focused captive insurer owned by private equity investment giant Blackstone.

That $50 million parametric cat bond transaction, which came to market earlier this year, secures Blackstone a source of contingent risk financing should a major earthquake strike an area where its real estate related exposures are high.

Another great example of a financial institution taking a proactive step to reduce its exposure to catastrophe risks using an ILS structure and third-party reinsurance capital is the Sierra Ltd catastrophe bonds.

These two cat bonds, a $200m Sierra Ltd. (Series 2021-1) and a $225m Sierra Ltd. (Series 2019-1), provide parametric insurance protection from the capital markets to Bayview Asset Managements Cayman Islands based Bayview MSR Opportunity Master Fund, LP, a mortgage focused investment strategy.

Here, Bayview is cleverly using the ILS market to carve out some of its earthquake exposure held within a portfolio of mortgage loans, so this is very similar to what US banks could be doing with their loan portfolios, to reduce their exposure to climate related risks.

With coastal flooding and also tropical storm related exposure particularly high in the US banks loan portfolios, it’s clear the ILS market would have the appetite to absorb some of this, on a parametric basis and issued as catastrophe bonds.

The traditional reinsurance market and other collateralised reinsurance structures would also be able to absorb some more.

As the world gains a better understanding of how much climate, weather and catastrophe risk is embedded in portfolios of investments, assets and institutions, the need to transfer some of that, or at the least secure contingent capital to hedge or buffer against losses, is expected to rise.

That’s a real opportunity for ILS capital to demonstrate its appetite for and ability to provide a financial buffer against physical climate related risks, so we hope to see more institutions like banks looking closely at how they can carve some of these exposures out, to reduce the risks to their balance-sheets, investors, shareholders, stakeholders and also the communities that could be affected.

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