Banks are having to come up with new strategies faced with the escalation in the number of climate-related disasters. Four economists – including Rong Ding, professor of accounting at NEOMA Business School – recently published an article in the European Journal of Finance on the ramifications. They showed how banks can minimise the economic and systemic impacts by diversifying the loans they grant and integrating climate risks into their assessments.

Storm over Texas. Several tornadoes struck the southern United States in late May, destroying dozens of houses and public infrastructure. Many homes were either without electricity or were too dangerous to be occupied, meaning their residents were forced to look for emergency accommodation elsewhere. A fortnight earlier, a violent storm had already killed at least seven people in the same state in addition to causing severe damage.

It is likely that disasters such as these will become more commonplace in the future as a result of global warming and human activity – so the IPCC warns us on a regular basis in its reports. Storms, tornadoes, tropical cyclones – or, by contrast, heat waves, drought and fires – are expected to keep on turning our lives upside down, especially in the Global South, which has been relatively spared until now.

“Interstate syndicated loans” exposed to climate hazards

In an attempt to contain the damage, a number of scientific and academic researchers are working on understanding how to limit global warming or at least curb its worst effects. While we are beginning to know more about certain general principles – changing the energy model, cutting the level of consumption in rich countries, etc. – others are more surprising. A recent economic study throws light on how some banks are more resistant to climate disaster than others.

 It is less well-known that extreme, unexpected events also destabilise the banking and financial system, as the article points out in its introduction. The more loans these institutions grant to individuals or organisations (private companies, governments, states, etc.) that are hit by these disasters, the greater the risk that the outstanding sums will not be repaid. And if large numbers of debtors were to fall victim simultaneously to a catastrophe that no one had predicted, then the situation might even develop into an economic crisis. This insight, which was seemingly well-founded, had not previously been put to the test using a more scientific approach – which is exactly what this four-person article set out to do. The research team honed in on the specific case of “inter-state syndicated loans” – i.e. when several states join forces to borrow more money.

Spotlight on a new climate risk exposure index

The researchers compared two major data types: first, indicators widely used to assess the damage caused by climate-related disasters – based on the number of deaths, the volume of property destroyed, the financial losses, etc. – in different states in North America. And, secondly, statistical tools, which are conventional in the world of economics, to evaluate the risk of a bank not being repaid when it makes a loan. Against this background, the idea was to create a climate risk exposure index: as well as naming the most vulnerable states, this would be used to check whether banks really are having more trouble recovering their loans in these same regions.

Without going into too much detail about the calculations used, the study clearly supports this hypothesis: when exposure to climate risk increases by one standard deviation (a statistically meaningful unit of measurement), all the indicators turn red for credit institutions. The economists draw particular attention to an increase in the “marginal expected shortfall” – the average loss that a bank can expect to incur in worst-case scenarios – of 14.7% in the short term and 1.3% in the longer run. The maximum probable loss – known to economists as the “value at risk” – follows a similar path, as does the possibility that the financial system as a whole will be destabilised (“systemic risk contribution”). A single conclusion emerges from the array of quantitative analyses designed by the researchers: the statistical correlation between climate disaster, unpaid loans and the destabilisation of the economy should sound the alarm.

The strategies of the least exposed financial institutions

At the same time, the study also identifies banks that are less at risk than others, either because of their long-term management or the way they react to events. In an emergency, when borrowers are hit by a disaster, some financial institutions cut their lending activity at the same time as increasing money reserves to offset future losses. This forward-looking policy seems to alleviate the harmful effects and, by extension, inoculate the financial system against disruptions – although this last point still has to be corroborated by future studies, warn the authors. Along the same lines, the most profitable banks in normal times seem to benefit from a safety cushion when there is a crisis. This then helps them better absorb the shock of climate-related disasters.

In broader terms, continue the authors, banks are well-advised to include more indices of climate risk exposure in their evaluations to help steer their lending policy more effectively. By the same token, the study emphasises that “Central banks and financial regulators have started to design scenarios for climate stress tests to gauge how vulnerable the financial system is to climate change”. In the future, all economic stakeholders will reap the benefits of embracing a more cautious, forward-looking policy that factors in the new risks of global warming.

Find out more

Thomas Conlon, Rong Ding, Xing Huan & Zhifang Zhang, Climate risk and financial stability: evidence from syndicated lending, The European Journal of Finance, April 2024. https://doi.org/10.1080/1351847X.2024.2343111