New research project examines the impact of climate change on banks’ credit risk

For a long time, sustainability was on everyone’s lips. However, the focus now seems to be shifting, with global competitiveness once again becoming the primary concern. Yet climate change remains a reality, and its impacts are becoming increasingly noticeable. Therefore, the responsibility of businesses to contribute to climate protection remains unchanged. The financial industry, in particular, plays a key role here. As a lender to the economy, it is its task to address climate risks. What is still lacking, however, are clear guidelines on how to do this effectively and in a practical manner.

This is where the research project “Quantifying climate-related capital demand for credit risk” comes in, funded by the Frankfurt Institute for Risk Management and Regulation (FIRM). Professor Dr. Christina Bannier from Justus Liebig University Giessen and Sebastian Rink from Frankfurt School of Finance & Management are investigating the impact of climate change on banks’ credit risk, examining current modeling approaches, and exploring innovative solutions.

Requirements for lending

Since the Paris Climate Agreement of 2015 and the adoption of the United Nations’ 2030 Agenda for Sustainable Development, numerous national and international initiatives have focused on ESG. In Europe, the European Central Bank (ECB) and the European Banking Authority (EBA) have issued comprehensive guidelines requiring the integration of ESG factors into banks’ lending processes and capital planning. Against this backdrop, banks must not only manage their credit risk more effectively but also ensure they hold sufficient capital buffers to absorb climate-related risks. The aim of the research project is to determine how these capital requirements can be quantified using new approaches.

At the core is the development of a scenario-based approach that integrates climate scenarios into risk management and analyzes their impact on capital requirements. Five key steps cover the essential elements of risk assessment in banks:

• Analysis of relevant climate scenarios: Selection and evaluation of climate scenarios that reflect banks’ specific risk profiles.
• Definition of transmission channels: Examination of how physical and transition risks affect traditional risk categories such as credit, market, and operational risks.
• Derivation of risk events: Development of a standardized methodology to derive concrete risk events from climate scenarios.
• Quantification of capital demand: Exemplary calculation of capital requirements based on hypothetical portfolios.
• Comparison with existing capital buffers: Analysis of whether current bank capital buffers are sufficient to cover climate-related risks.

Developing practical solutions for banks

The results are intended to help banks more precisely calculate capital requirements related to climate risks. This will enable them to adjust their capital planning and risk management strategies accordingly and ensure compliance with regulatory requirements. The project is designed to run for 12 months and officially started in September 2024.