Review the article by Mayra Rodriguez Valladares (2021) and the conclusion of the paper by Basel Committee on Banking Supervision Climate-related risk drivers and their transmission channel, April 2021, and show how you can apply what was covered in BUS307 in a real-world situation. Insightful observations and discussion will attract a superior grade. Conversely, inserting paragraphs/sections from your texts, the internet, and the Valladares (2021) article will not be viewed favourably. Also, recall that plagiarism can result in a zero grade. Be concise.

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Banks Can Suffer Financial Losses From Physical And Transition Climate Change Risk Drivers

Apr 14, 2021,

Mayra Rodriguez Valladares Senior Contributor, Banking & Insurance

The physical and transition climate change risk drivers are likely to generate significant costs and financial losses for banks and the banking system globally. Both banks and bank supervisors need to evaluate banks existing risk management policies, processes, and procedures to assess whether banks are sufficiently capitalized and liquid to cope with climate-change related risks.

Climate-related Risks, Opportunities, and Financial Impact

The increasing severity and frequency of physical climate risk events can have a significant adverse impact on the borrowers, counterparties and service providers interconnected to banks as well as to the physical properties of banks. Natural disasters, for example, can cause borrowers and banks counterparties financial losses which in turn could make them unable to meet their obligations to banks; natural disasters can also lead to market volatility which would make pricing collateral posted by borrowers or counterparties difficult to value accurately.

Estimated Global Economic Loss From Natural Catastrophe Events (Not all natural catastrophes) Bank for International Settlements, Banque de France, and MunichRe

Banks and the banking system will also be affected by climate-change transition risks. As more and more countries are trying to reduce their carbon emissions, changes in technological developments, government policies, financial regulations, or investor and consumer sentiment can also impact banks business strategies, cost structure, and earnings.

Transition Risks

Climate-related risk drivers and their transmission channels a report published by the Basel Committee on Banking Supervisions Task Force on Climate-related Financial Risks (TFCR) suggests that these physical and transition drivers impact on banks can be observed through traditional risk categories at banks. The following TCFR table below summarizes the potential effects in each risk type:

Physical and Transition Climate Risk Drivers, Basel Committee on Banking Supervision, TCFR

Importantly, the TFCR explains that thus far, existing literature largely focuses on the impacts of climate risk drivers on those aspects of the economy relevant to banks credit risk, and to a lesser extent on market risk. Unfortunately, there is little work that takes climate risk drivers all the way through to the impact on banks. Presently, there is a lot more data and information on the impact of physical risks on banks and the banking system. Because trying to estimate the impact of transition risks is forward looking by nature, the analysis of transition risks is focused on scenario analysis. To better understand transmission channels going forward, analysis on the realized impact of transition risks on banks across various jurisdictions would be valuable.

Climate-change related risks will impact banks around the world differently due to the structure of a countrys economy, financial markets, and the availability of property insurance. As the TFCR report explains differences in factors such as geographical location, topography and proximity to water mean some regions are expected to experience more severe storms, more frequent droughts or greater and more concentrated precipitation in response to rising temperatures. Additionally, banks will be exposed to different levels of transition risk depending on the likelihood of governments or financial regulators policy actions, technological innovation or broad shifts in consumer and investor sentiment in different countries. According to the TFCR, More comparative analysis on differences in the impact of climate risks arising from variations in economies and market structure would inform our understanding of transmission channels.

There will definitely be a bigger role for the international standard setter for banks, Basel Committee on Banking Supervision, to play in recommending principles or policies for banks and bank regulators in the area of climate-related risks. Given that the BCBSs members hold the largest percentage of banking assets globally, the BCBS is in a very good position to analyze whether and how climate-related financial risks could be incorporated into the Basel III risk management framework or whether new principles or even a new framework might be necessary. According to the TFCR, part of the Basel Committees near-term work would be to identify gaps in the current Basel Framework, where climate-related financial risks may not be sufficiently addressed. The BCBS works should be comprehensive and could be the foundation for the Committees future work in exploring possible measures to address gaps where relevant.

Financial Risks from Climate Risk Drivers, BCBS, April 2021

Basel Committee on Banking Supervision Climate-related risk drivers and their transmission channel, April 2021

Climate risk driver: Microeconomic Transition risk transmission channel: Government policy, techonological change and households, corporates and sentiment sovereigns \begin{tabular}{ll} \hline Risk & Potential effects of climate risk drivers (physical and transition risks) \\ \hline Credit risk & Credit risk increases if climate risk drivers reduce borrowers' ability to repay and service debt (income effect) or banks' ability to fully recover the value of a loan in the event of default (wealth effect). \\ \hline Market risk & Reduction in financial asset values, including the potential to trigger large, sudden and negative price adjustments where climate risk is not yet incorporated into prices. Climate risk could also lead to a breakdown in correlations between assets or a change in market liquidity for particular assets, undermining risk management assumptions. \\ \hline Banks' access to stable sources of funding could be reduced as market conditions change. Climate risk drivers may cause banks' counterparties to draw down deposits and credit lines. \\ \hline Operational risk & Increasing legal and regulatory compliance risk associated with climate-sensitive investments and businesses. \\ \hline Reputational risk & Increasing reputational risk to banks based on changing market or consumer sentiment. \\ \hline \end{tabular} Figure 1: Financial risks from climate risk drivers This report has surveyed existing literature to explore how climate risk drivers impact the financial risks of banks and banking systems via a range of transmission channels. It concludes with two recommendations for areas of focus in future public, private and academic work. 5.1. Potential impacts on traditional risk categories This report suggests that the impacts of climate risk drivers on banks can be observed through the traditional risk categories. The table below summarises the potential effects in each risk type: To explore these linkages further, consideration could be given to how climate-related financial risks can be incorporated into the existing Basel Framework. Part of the Basel Committee's near-term work on climate change would be identifying gaps in the current Basel Framework, where climate-related financial risks may not be sufficiently addressed. This mapping exercise would be comprehensive in nature and could act as a conceptual foundation for the Committee's future work in exploring possible measures to address these gaps where relevant. 5.2. Research across all risk types and increased data availability There is a limited amount of research and accompanying data that explore how climate risk drivers feed into transmission channels and the financial risks faced by banks. Existing analysis does not generally translate changes in climate-related variables to changes in banks' credit, market, liquidity or operational risk exposures or to bank balance sheet losses. Instead, the focus is on how specific climate risk drivers can impact: narrowly defined sectors of particular economies; individual markets; and/or a top-down assessment of the macro economy as a whole. Nevertheless, these examples provide insights on transmission channels and help to demonstrate heterogeneity in climate impacts across geographic, sectoral and jurisdictional boundaries. A better understanding of risk drivers and their transmission channels, across all risk types, would be gained from further research. Research would also benefit from more granular information that is often privately held, for example more granular borrower data for credit risks. The table below summarises the areas where further analysis would be valuable: 32 Climate-related risk drivers and their transmission channels The lack of research on banks' climate-related financial risks partially arises from a lack of data availability. Researchers interested in quantifying the impacts of climate change may not have access to the exposure data needed to assess these risks. The emergence of national climate-related stress testing exercises may partially address this information gap, but more could potentially be done to create opportunities for collaboration between climate and finance experts. More research on the importance of different amplifiers and mitigants of climate-related financial risk would help inform where banks and supervisors could usefully focus their resources. Institutions are starting to conduct assessments that estimate the combined effect of climate-related financial risks on bank loan books and trading portfolios. This represents an evolution from the more narrowly focused studies on credit, market, liquidity or operational risk. However, most studies do not model the efficacy of mitigants or the propagation and potential amplification of the impacts that climate risk drivers may have across the financial system. Whilst the literature is increasingly exploring how these channels arise, understanding of this area remains undeveloped. More research is needed on how these effects could result in aggregate impacts that are greater than the sum of the individual parts. Climate risk driver: Microeconomic Transition risk transmission channel: Government policy, techonological change and households, corporates and sentiment sovereigns \begin{tabular}{ll} \hline Risk & Potential effects of climate risk drivers (physical and transition risks) \\ \hline Credit risk & Credit risk increases if climate risk drivers reduce borrowers' ability to repay and service debt (income effect) or banks' ability to fully recover the value of a loan in the event of default (wealth effect). \\ \hline Market risk & Reduction in financial asset values, including the potential to trigger large, sudden and negative price adjustments where climate risk is not yet incorporated into prices. Climate risk could also lead to a breakdown in correlations between assets or a change in market liquidity for particular assets, undermining risk management assumptions. \\ \hline Banks' access to stable sources of funding could be reduced as market conditions change. Climate risk drivers may cause banks' counterparties to draw down deposits and credit lines. \\ \hline Operational risk & Increasing legal and regulatory compliance risk associated with climate-sensitive investments and businesses. \\ \hline Reputational risk & Increasing reputational risk to banks based on changing market or consumer sentiment. \\ \hline \end{tabular} Figure 1: Financial risks from climate risk drivers This report has surveyed existing literature to explore how climate risk drivers impact the financial risks of banks and banking systems via a range of transmission channels. It concludes with two recommendations for areas of focus in future public, private and academic work. 5.1. Potential impacts on traditional risk categories This report suggests that the impacts of climate risk drivers on banks can be observed through the traditional risk categories. The table below summarises the potential effects in each risk type: To explore these linkages further, consideration could be given to how climate-related financial risks can be incorporated into the existing Basel Framework. Part of the Basel Committee's near-term work on climate change would be identifying gaps in the current Basel Framework, where climate-related financial risks may not be sufficiently addressed. This mapping exercise would be comprehensive in nature and could act as a conceptual foundation for the Committee's future work in exploring possible measures to address these gaps where relevant. 5.2. Research across all risk types and increased data availability There is a limited amount of research and accompanying data that explore how climate risk drivers feed into transmission channels and the financial risks faced by banks. Existing analysis does not generally translate changes in climate-related variables to changes in banks' credit, market, liquidity or operational risk exposures or to bank balance sheet losses. Instead, the focus is on how specific climate risk drivers can impact: narrowly defined sectors of particular economies; individual markets; and/or a top-down assessment of the macro economy as a whole. Nevertheless, these examples provide insights on transmission channels and help to demonstrate heterogeneity in climate impacts across geographic, sectoral and jurisdictional boundaries. A better understanding of risk drivers and their transmission channels, across all risk types, would be gained from further research. Research would also benefit from more granular information that is often privately held, for example more granular borrower data for credit risks. The table below summarises the areas where further analysis would be valuable: 32 Climate-related risk drivers and their transmission channels The lack of research on banks' climate-related financial risks partially arises from a lack of data availability. Researchers interested in quantifying the impacts of climate change may not have access to the exposure data needed to assess these risks. The emergence of national climate-related stress testing exercises may partially address this information gap, but more could potentially be done to create opportunities for collaboration between climate and finance experts. More research on the importance of different amplifiers and mitigants of climate-related financial risk would help inform where banks and supervisors could usefully focus their resources. Institutions are starting to conduct assessments that estimate the combined effect of climate-related financial risks on bank loan books and trading portfolios. This represents an evolution from the more narrowly focused studies on credit, market, liquidity or operational risk. However, most studies do not model the efficacy of mitigants or the propagation and potential amplification of the impacts that climate risk drivers may have across the financial system. Whilst the literature is increasingly exploring how these channels arise, understanding of this area remains undeveloped. More research is needed on how these effects could result in aggregate impacts that are greater than the sum of the individual parts