Climate risks are of growing concerns for the banking system. In order to understand why climate risks are so important for banks, we can start by having a look at the typical asset structure of a bank, at the balance sheet of a commercial bank. On the left side, we have mortgages and loans that commercial banks extend to households and businesses. On the right side, we have deposits and we have the equity, the capital of the bank. We can say that the job of a commercial bank is actually to transform deposits into mortgages and loans. These peculiar structure of the business is also reflected in the peculiar income statement for a commercial bank. The starting point is the interest income, is the interest that the bank is able to generate on the mortgages and on the loans. Then we have to consider the interests expenses. Those are the interests that the commercial bank pays on deposits. We can say that commercial banking is a spread business in the sense that the two main drivers are the interest income and interest expenses. As long as there is a positive spread between interest income and interest expenses, the business of the commercial bank is healthy. We also have to consider the possible assets impairment. We should consider the possible loss of value for the assets in the balance sheet of the bank. For example, loans may at a certain point for various reason be worth less than what is reported in the original balance sheet of the bank. After that, we have to consider the operating expenses for the commercial bank to run its operations, the taxes, and eventually the bottom line of the income statement is net income, also known as the net profit, or net loss, if the business is not doing well. When thinking of the economics of commercial banking, credit risk is the dominant source of risk. Credit risk is watched carefully by regulatory bodies and supervising authorities in the financial system. Credit risk is commonly defined as the loss resulting from failure of borrowers to honor their loans. In particular, a key metrics for banks is the probability of default of the borrowers. Probability of default is the likelihood over a specified period of time that the borrower will not be able to make the scheduled interest or principal payments. Bank loans and mortgages are exposed to various degrees to both climate transition and physical risks. Therefore, the exposure to those risks is reflected in the credit risk of the banks. Assessment of the physical risks of climate change need to consider the impact of both shifts in the climate conditions and the changes in extreme events. Both these sources of physical climate risks are of great importance for commercial banks. Incremental changes, such as the rising temperature and changes in precipitation patterns, can affect the output and productivity for certain industries. They can determine loss of production and therefore a loss of the value of certain assets. These can have implications for the commercial banks, who have financed, through a loan or a mortgage, a certain business. Extreme events, which are increasing in both frequency and intensity, often attract more attention as their impact is typically more apparent. However they are not the only or necessarily the most relevant source of risk for commercial banking. Extreme events tend to occur in specific locations, for example, in the tropics. They require banks to have the ability to assess the probability of their borrowers being impacted by these events. If we think, for example, of the agriculture industry, there may be households or businesses that either obtain a mortgage or a loan from a commercial bank. An increase in the physical climate risks, for example, in terms of the frequency and severity of a tropical storms, can have an impact on the revenues of these households and these businesses. The consequence is that the probability of default for the borrower is getting higher and therefore the credit risk for the bank becomes higher as well. If we look at the different industry, for example, energy. Energy companies tend to be exposed especially to climate transition risk. For example, because of the implementation of national carbon pricing mechanisms, which are getting more and more important with carbon prices that are getting more relevant. This implies that the costs for energy companies are getting more important as output as a consequence of increasing carbon prices applied to national and international level. If the cost gets higher then the possible profitability and capacity to generate an income for energy companies becomes lower, is shrinking. Therefore, this is again a possible source for an increase in the probability of default for the energy companies that have received the mortgages or loans from commercial banks. According to empirical evidences, property value, real state property values, can be affected and actually are affected by extreme weather events. There is a scientific evidence showing that, for example, hurricanes, which can lead to wind damage and flooding in certain areas, shows that affected houses or real estate properties decline in their aftermath value compared to the average market prices. Therefore, climate change can have an impact on real estate assets. This increase in a physical climate risk has an impact on the value of properties. A ratio that is typically used by banks when they extend a mortgage, the loan to value ratio is impacted as well. What is exactly the loan to value ratio? This is a ratio that is obtained by dividing the loan amount extended by the bank to the assessed value of the property. If the assessed value of the property shrinks because of the greater exposure to climate risk, this loan to value ratio increases. Higher loan to value ratios express a higher risk for the lender, for the commercial banks who has extended a mortgage to buy that property. Because of these apparent greater and relevant exposure of the commercial banks and in general of the banking system to climate risks over last few years, we have observed a series of very important regulations that have been implemented and decided on a global level. Just to make some examples, in 2017, the task force on climate related financial disclosures was created with the objective of making recommendations about the disclosure in a climate risk management approach with a specific focus for commercial banks, but not only commercial banks. In 2019, the Bank of England, so the Central Bank of the United Kingdom, issued a specific regulation about the extent to which the boards of banks in the United Kingdom had to factor climate risks in their decision-making. In this regulation, there was also a drafted methodology for a climate stress testing for commercial banks in the United Kingdom. More recently, the European Banking Authority is pushing for a more clear and structured integration of environmental, social, and governance factors in the way commercial banks in Europe treat climate risks and not only climate risks. There is a growing pressure from supervising authorities and from regulators to incorporate climate considerations in banking management and risk evaluation. Of course, climate does not only pose downside risk, but it also opens up opportunities, so banks are also evaluating the growing opportunities to support borrowers finance requirements in climate adaptation, for example. Global markets are developing for providers of climate-related products and services, for example, companies that provide engineering and technology solutions to climate change, ways to capitalize on these opportunities, and commercial banks can exploit and participate in these efforts to make possible the transition towards a low-carbon world.
