The Federal Reserve Board will require banks to confront climate risk as part of a climate scenario analysis pilot program
Co-Authored: George Gallagher, ESG, Climate Risk, Natural Hazard and Spatial Solutions & Kent David, Senior Leader, Analytics Consulting
Loan and property portfolios held by banks are comprised of real properties that are subject to real physical risk from natural hazard perils. So, it’s important to forecast the future risk associated with an investment. While some areas of the U.S. are inherently safer for property, locating those areas and understanding how the evolving climate will affect physical risk is a tall order.
Millions of properties are exposed to significant physical risk from climate change challenges such as wildfire, flood, severe convective storms, hurricanes and earthquakes. And the Federal Reserve Board (FRB) is looking to ensure that supervised institutions such as banks are “appropriately managing all material risks, including financial risks related to climate change.” To this end, the FRB is conducting a Climate Analysis Exercise due July 31, 2023, to learn about climate risk management practices in large banking organizations.
Achieving this goal requires banks and financial institutions to understand how climate change will evolve and how the associated physical risk will affect their portfolio. That presents something of a challenge, but not one that is insurmountable. Below are five challenges banks face when predicting the future health of property portfolios and how to overcome them.
1. Calculating Physical Risks in Non-Credit Terms
The banks are savants when it comes to understanding credit capabilities, but they’ve not often been asked to examine climate-related physical risks, so it’s rare that they have a strong methodology at the ready.
There is a learning curve here, and banks should lean on what they know about credit risk to solve these questions of physical risk.
2. Lack of Common Terminology
One of the challenges when talking about physical risk is that terminology differs among experts.
Establishing a common language is a step in the right direction for the industry, and the FRB’s pilot exercise prescribes a framework for better physical risk conversations.
3. Financially Quantifying Physical Risk
The challenge with determining physical risk is trying to figure out how much collateral is worth and what parameters are required to adjust those dollar and cents figures for the future. Do banks have access to all the collateral information they need for these calculations?
To ensure the answer to that question is a resounding “yes,” it is important to know the replacement costs for homes across different locations.
4. Understanding the Probability of Default
The probability of default is a large equation to solve, and credit risk is just one variable. Physical risk and transition risk are also factored into the equation, and the sum of all these risks should add up to the total probability of default.
To make that math work, banks may have to rework their worldview of what the probability of default is.
5. Complex Climate Risk Variables Are Very Different From Credit Risk Variables
The challenge with climate risk is that there are so many variables to consider. Sea level rise, for example, varies up and down the East Coast. Hurricanes impact properties in widely different ways depending on how a storm forms and when and how a property was built.
The geographic distribution and time horizons associated with those risks are important when quantifying these phenomena. While modeling future scenarios that include evolving climate risks in varying severity scenarios can make calculations more complex, solving them is not impossible.
With CoreLogic® Climate Risk Analytics, you can leverage composite risk scores for every property in your portfolio, assess up-to-date material costs to rebuild by region and lessen the impact to your bottom line. Our solution can quickly help you measure, model and mitigate your risk to help protect your assets now and in the future.
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