Insights: Banking on sustainability, mitigating risks
To effectively manage and mitigate risks arising from climate and other factors, it is crucial for banks to modernise their systems, for now and the future
Climate change and sustainability have emerged as crucial topics in recent years, reflecting a heightened global consciousness and dedication to tackling environmental issues. In the UAE, the fight against climate change has been listed as a priority target for sustainability and growth, to achieve its Green Agenda 2030.
The ramifications of climate change extend to the financial services sector as well. Financial experts are increasingly focusing on climate scenarios, recognising the impact on the business and reputation of banks that want to adapt to the increasing sustainability requirements of their customers and the wider industry. However, many financial institutions still encounter challenges in effectively integrating climate scenarios into existing risk management structures.
While risk assessment is not a new topic in the financial world, the need to increase awareness of financial impacts due to climate change has never been more pressing.
‘Risk’ often carries negative undertones in everyday language, however, in the context of risk management, it signifies proactive preparation for forthcoming events. This includes all external factors that impact companies, banks and investors, including future implications of climate change.
What are climate scenarios?
In risk management, climate risks are bifurcated into physical and transitional categories. The former encompasses events like intensified heavy rainfall, like we’ve experienced in April last year, while the latter stems from societal shifts toward a low-carbon or carbon-free economy. Physical risks cause repercussions that can range from acute to chronic scenarios. For example, recurring heavy rainfall may trigger localised floods, alongside causing substantial damage.
To provide context, imagine a scenario where a small company builds a production facility that is unexpectedly flooded by heavy rainfall and is rendered inoperable for months. This not only affects its revenue stream and turnover but also presents challenges in meeting financial obligations such as repaying bank loans.
Consequently, the business finds itself vulnerable to immediate physical risks, which cascade into credit and repayment challenges. While factors pertaining to weather remain largely unpredictable, historical data can indicate which regions are more prone to heavy rainfall than others. Although this does not directly disqualify businesses in these areas from loan eligibility, banks can use this insight to proactively identify and mitigate such risk factors.
Chronic risks are also becoming increasingly realistic. The increasing frequency and intensity of heat waves, or the fact that traditional crops in the Middle East such as wheat no longer thrive as well as they used to, have a long-term impact on agriculture. Rising sea levels also fall into this category and affect the value of coastal property.
While it might seem feasible to overlook the financial implications of climate change, disregarding these risks does not erase them. Failing to acknowledge climate risks is akin to navigating the world blindfolded, making it impossible to see challenges or obstacles, let alone overcome them. Effective risk management involves removing this blindfold, enabling us to identify issues, quantify them, and thereby address them. In this light, the establishment of the United Arab Emirates Ministry of Climate Change & Environment, presents a significant opportunity to promote constructive change, catalyse innovative solutions and drive collaborative effort towards a sustainable future.
How can banks prepare to support sustainability
To effectively manage and mitigate risks arising from climate and other factors, it is crucial for banks to modernise their systems, for now and the future. By investing in appropriate technological solutions, financial institutions can, for example, utilise their data more effectively and leverage robust risk analytics and real-time insights to make more informed decisions.
Embracing open finance and ecosystems further enhances the efficiency and impact of managing climate risks. For instance, integrating third-party applications, through open APIs, that offer access to comprehensive climate datasets, enables banks to gain deeper insights into the specific risks affecting their customers. With technologies such as AI and generative AI, institutions can better analyse this data to enhance risk modelling, climate change scenario planning and ultimately decision-making.
Effective risk management involves developing and employing an awareness of the implications of climate change. This entails assessing the impact of climate scenarios on portfolios, estimating potential profits, losses, changes in value, and being attuned to possible developmental trajectories to prepare for the future.
While such risk assessments were not traditionally common when granting loans, given the rapid progression of climate change, banks must effectively equip themselves to both remain competitive and fit for the future, while contributing to a greener society for all.
The writer is a lead solutions consultant, Treasury & Capital Markets at Finastra
Read: The path to sustainable business through ESG compliance
