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This note discusses the implications of physical risk from climate change for local banks. Our discussion suggests that inherent characteristics such as geographical concentration, limited size and significant support to the agricultural sector may expose local banks to physical risk at a greater extent than other bank types, mainly via the lending channel. In addition, we argue that physical risk may have a negative impact on the lending capacity of local banks when they have limited access to risk-sharing mechanisms, face obstacles in raising capital or fail to effectively integrate physical risk into existing risk management frameworks due to lack of data or expertise. These elements are expected to affect local banks unevenly, depending on the specific impact of climate change in the geographic areas where they operate and on their organisational structure (e.g. whether or not they are part of a group or network). In this context, we also discuss what role relationship banking and availability of soft information can play in the management and pricing of physical risk.
The summer of 2023 is likely to be remembered by many as one of the hottest summer seasons in recorded history1. Natural ecosystems, human beings as well as businesses and other economic players all experienced the unprecedented consequences brought about by destructive heatwaves, wildfires and droughts, which are but a few examples of extreme weather-related events that are bound to increase in both frequency and magnitude within a warmer climate (e.g. IPCC, 2018). In line with the potentially catastrophic consequences for nature and people, there is an increasing awareness concerning the effective materiality of climate change for businesses, households, public institutions and financial intermediaries (e.g. BCBS, 2021; Bolton et al., 2020).
This note discusses the implications of physical risk from climate change for local banks. We define local banks as banks of relatively small size that primarily serve local businesses and households and are closely embedded in local economies. Local banks are essential actors for the development of local communities and territories, and often play a distinctive role within the financial system by extensively serving small and medium enterprises, households and associations (e.g. Ferri et al., 2014; Masera, 2019).
This note begins with an overview of physical risk and its transmission channels to banks’ financial risks. The central part of the note reviews the main features of local banks that are likely to affect the impact of physical risk drivers on local banks’ lending. This analysis includes the main findings from our current work on the impact of physical risk on credit risk for the US banking sector. The note concludes by discussing some key policy considerations and by highlighting the need for further research.
The profound consequences of climate change for nature and the economy have spurred growing interest in understanding how banks and other financial institutions may be impacted by climate risks. Mark Carney, former Governor of the Bank of England and former Chair of the Financial Stability Board, was the first to propose a typology of climate-related risk factors in a famous speech given at Lloyd’s London in September 2015 (Carney, 2015). In describing climate change as the ‘Tragedy of the Horizon’, Carney (2015) explains that climate change may influence financial risks and the stability of the financial system at large via three main channels: physical risk, transition risk and liability risk. This note focuses on physical risk2.
Physical risk indicates the direct losses caused by long-term shifts in climate patterns or extreme weather events. Long-term shifts in climate patterns (chronic physical risk) include higher average temperatures, melting glaciers and rising sea levels. Examples of extreme weather events (acute physical risk) are hurricanes, droughts, floods and heatwaves. All these risks have the potential to cause severe disruption to businesses and life, even forcing the relocation of companies and households away from affected or exposed areas. Chronic and acute physical risk factors are closely interconnected, in that extreme weather events are exacerbated by long-term shifts in climate patterns (IPCC, 2021).
Many of the risks associated with a changing climate, including physical risk, present new features such as non-linearity, (likely) fat-tailed probability distributions, interconnectedness and irreversibility (e.g. BCBS, 2021; Bolton et al., 2020). Nevertheless, researchers and policymakers agree that climate-related risks should not be treated as a standalone category but rather as an additional source of financial risks. In this sense, physical risk from climate change has the potential to transmit to credit, market, liquidity and operational risk (e.g. Migliorelli, 2023)....
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