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ECB on Climate Risks: What Banks Need to Know
Discover how the ECB’s climate stance is shaping risk management strategies.
Christine Lagarde, President of the European Central Bank (ECB), recently highlighted the importance of climate and environmental risks for the financial sector.
This post outlines five key implications for risk managers, particularly in the context of mortgages, loan origination, ESG, and climate risks, drawing insights from Lagarde’s speech and our experiences at SkenarioLabs.
1. Systemic Nature of Climate Risks
Lagarde underscored that climate risks are systemic, posing significant long-term threats to financial stability. These risks are certain to impact financial systems unless mitigative actions are taken, as evidenced by recent devastating floods in central Europe.
She contends that the evolution of climate risks breaks from the “classical Gaussian probabilistic universe” in that it effectively presents a certainty of adverse impact, rather than a “risk” in the traditional sense without mitigation efforts.
This is not a challenge that existing risk models are built to respond to, especially on a large scale. Lagarde’s underlying implication is that financial institutions are in essence under-prepared for what are fundamentally impending events, rather than potential ones. Hence banks should enhance their capacity to assess and manage physical risks from climate change, such as extreme weather events, which significantly impact real estate values and portfolio performance.
Banks and financial institutions must embed climate risk assessments into all decision-making processes, ensuring that climate risks are evaluated and managed proactively. Advanced stress testing models should be adopted to understand the potential impacts on asset portfolios. Credit ratings should factor in climate-related risks, impacting the borrowing costs for home buyers and real estate projects. Banks must adapt their risk assessments accordingly.
2. Data Quality & Accessibility
The speech makes clear that institutions need to make decisions based on a complex, long-term view of the climate and its impact on their portfolios. This cannot be done without a sound understanding of the exact location, type, usage, and exposure of each individual asset within its own context. The fact is that despite the digitisation of banks, many institutions still lack reliable data from their assets and investments.
Interestingly, there is evidence that loan officers approve fewer mortgage applications and originate lower amounts of loans in abnormally warm weather – this is perceived to be decision-making taken by individual officers (the trend is higher in smaller lenders) based on recent experience alone. This kind of trend can hurt banks’ core business in the long run as risk management decisions are taken by “gut” and not by models adapted to the current and future climate. Strengthening the access to good quality data for loan officers should help to reduce this by ensuring that decisions are made in line with the approach Lagarde is advocating.
Investing in data infrastructure and analytics capabilities is crucial. Partnering with specialised data providers and leveraging technologies like AI and Machine Learning (ML) can improve data quality and accessibility, supporting better decision-making. Moreover, better data and training employees to understand these factors can prevent business loss.
3. Green Loan Origination & Real Estate Valuation
Lagarde pointed out that the ECB is committed to integrating climate considerations into its monetary policy, stressing that financial institutions have a role in steering capital towards more sustainable investments. Banks should take this as a cue to prioritise green finance and support companies in reducing their carbon footprint. This involves developing financial products, like green bonds and sustainability-linked loans, to help drive the transition to a low-carbon economy and mitigate future financial risks associated with climate change.
Banks should refine loan origination processes to include sustainability criteria, leveraging advanced valuation models that account for energy efficiency improvements. Aligning loan products with green finance frameworks will be crucial.
4. Market & Economic Volatility
Climate-related disruptions are anticipated to increase economic instability. Lagarde’s speech pointed out that banks must prepare for heightened market volatility driven by climate events and the transition to a low-carbon economy.
Increasing economic volatility combined with increasing regulation means more work for risk managers. Enhancing risk mitigation strategies to cope with market volatility is essential. This includes diversifying portfolios, implementing dynamic risk assessment tools, and maintaining sufficient liquidity buffers to withstand economic shocks. Automation can help risk managers do this effectively.
5. The Climate Insurance Gap
Christine Lagarde’s observation that “only about a quarter of losses owing to climate-related catastrophes are currently insured in the EU” highlights a critical vulnerability in the financial system. This underinsurance, especially in countries where coverage is less than 5%, leaves economies exposed to significant financial risks when disasters strike. The implications are profound: uninsured losses can lead to economic instability, strain public resources, and exacerbate social inequalities.
To address this gap, banks and insurers must develop more inclusive and affordable insurance products that are accessible to a broader range of businesses and individuals. This requires innovation in insurance offerings, such as microinsurance or parametric insurance products, which can provide coverage tailored to the specific needs of at-risk populations and regions. Additionally, collaboration between governments and the private sector could help establish public-private insurance schemes that share the burden of catastrophic losses, ensuring that financial stability is maintained even in the face of increasing climate-related events.
Furthermore, raising awareness among businesses and individuals about the importance of climate risk insurance is essential. Financial institutions can play a crucial role in educating their clients about the potential impacts of climate change and the necessity of securing adequate coverage. By closing the climate insurance gap, banks and insurers can contribute to a more resilient financial system, better equipped to handle the economic challenges posed by climate change.
Rising opportunities
- Innovative Financial Products: Developing new green financial products and services can meet the growing demand for sustainable investments. These products and services could be for example smart energy improvement loans.
- Competitive Advantage: Banks that effectively manage ESG risks and integrate sustainability into their operations can differentiate themselves in the market. Credit ratings are factoring in climate-related risks and this gives opportunities for banks to create competitive advantage. Banks can also gain an edge with prudent valuations that take environmental risks into account.
- Regulatory Alignment: Proactively adapting to new regulations can enhance the bank’s reputation and reduce compliance risks. Automation, high-quality data and the usage of artificial intelligence (AI) can mitigate the burden of regulatory reporting.
What next?
Christine Lagarde’s speech underscores the urgent need for banks to adapt to the evolving landscape shaped by climate and environmental risks. By focusing on enhanced climate risk assessments, robust regulatory compliance, sustainable loan origination practices, market volatility mitigation, and data quality improvements, European bank risk managers can navigate these challenges and leverage opportunities for long-term stability and growth.
SkenarioLabs can assist bank risk managers in navigating these challenges and opportunities with innovative solutions tailored to your needs. We have automated services using AI and ML tools and can handle massive amounts of data, and are well-versed in navigating varying levels of property data quality and availability.
Here are key ways SkenarioLabs can help:
Risk
Assessment
Compliance
Support
Automated Valuation Models (AVMs)
Scenario
Planning
Data Quality
& Integration
Combining internal and external data sources for comprehensive risk assessment and decision-making support.
For more detailed insights, refer to the full ECB speech and related studies on climate and ESG risks. Learn more about SkenarioLabs’ services for banks and risk managers.
