Innovative stress testing tool helps banks understand risk of loan default driven by drought

Publication date

Ground-breaking, open source tool stress tested bank loan portfolios under drought scenarios in Mexico, Brazil, China and the US

LONDON: Financial institutions and environmental experts from across the globe have partnered in a project to develop a set of environmental risk stress tests that measure the credit worthiness of bank loans.

The ‘Drought Stress Testing Tool allows financial institutions to see how incorporating drought scenarios changes the perception of risk in their own loan portfolios. Based on the catastrophe modelling framework that the insurance industry has used for 25 years, it looks at five drought scenarios in four countries – Brazil, China, Mexico and the US – to model the impact on 19 different industry sectors, the companies in those sectors and the likelihood that they will default on their loans.

A new report, ‘Drought Stress Testing – Making Financial Institutions more Resilient to Environmental Risks’, showcases the tool in action by piloting the stress test on select, sample corporate lending portfolios of nine international financial institutions. These are: Caixa Econômica Federal, Itaú Unibanco, Santander Brazil, Banorte, Citibanamex, Trust Funds for Rural Development (FIRA), Citigroup, UBS and Industrial and Commercial Bank of China (ICBC), which combined represent more than USD 10 trillion in assets.

Key findings from the report include:

  • Extreme droughts could increase loan default losses 10-fold for specific portfolios that are most exposed to the effects of drought;
  • Even when exposed to less extreme drought scenarios, most companies in the analysed portfolios see their credit ratings downgraded;
  • The most affected sectors are water supply, agriculture and, in countries with high reliance upon hydroelectric energy, power generation;
  • Significant impacts are also found in water-dependent sectors such as food and beverage production;
  • Sectors that are less water-dependent but highly sensitive to general economic strength, such as petroleum refining, are also affected by widespread economic impacts of drought.

This project was financed by the Federal Ministry for Economic Cooperation and Development (BMZ), and developed jointly by the Natural Capital Financial Alliance (NCFA) and the Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH. A consortium led by global modelling experts Risk Management Solutions (RMS) designed, developed and implemented the tool and the framework which underlies it.

Linda Murasawa, Sustainability Head of Santander Brazil said: “We consider environmental risk management as an irreversible trend in the financial industry. Santander has a long-standing history of considering ESG in its risk assessments and of promoting sustainable business among its clients. Participating in this pilot was an excellent opportunity to further foster this agenda and to evolve our understanding of the possible impacts of droughts to our business. This tool will have immediate impact in terms of awareness raising and bringing the issue of environmental stress testing closer to mainstream risk management.”

Patricia Casillas, Specialist / Credit Department of Trust Funds for Rural Development (FIRA) said: “This tool can provide information that helps us to measure the potential risks associated with climate change; it offers a powerful and objective way to measure the impact of drought scenarios. We are already promoting changes in our management of water-related risks, but this tool offers information to better evaluate the most risky areas and industries, with clear, objective information to establish priorities. We are probably going to adjust our long-term investment strategies due to the results of this kind of analysis. In the near future, all banks are going to introduce climate modelling in their risk management methodologies, considering potential changes due to global warming. For us, this tool is the first step to do so in a formal way.”

Liselotte Arni, Head Environmental and Social Risk, UBS said: “While climate change is a global phenomenon, its impacts will vary across geographies. This project explored unchartered territory by modelling the impact of drought scenarios on lending portfolios. It has helped us better understand the data requirements in quantifying drought-related risk and the challenges that will need to be addressed to further develop climate-related risk quantification methodologies.”

Courtney Lowrance, Global Head of Environmental and Social Risk Management, Citi said: “The quantification of financial impacts arising from environmental risks, particularly those related to climate change, is an important step in the evolution of environmental and social risk management.  The focus on drought, a physical risk arising from climate change, is an important addition to the body of work related to stress testing, carbon emissions and climate change.‎

The development of the tool is timely, as it will inform how ‎institutions can conduct scenario analysis on climate change risks in alignment with the expected guidance from the Taskforce on Climate-Related Financial Disclosures.”

Jorge Sobehart, Managing Director, Risk Architecture, Citi said: “Calibrating scenario modelling to reflect how external environmental shocks could affect the credit quality of certain industries will be useful for stress testing.”

Dr. Yin Hong, Deputy Director of Urban Finance Research Institute, ICBC said: “Water-related risks have become increasingly serious all over the world. As one of the biggest commercial banks in the world, ICBC has spent many years in protecting our portfolios against environmental risk; water risk is one of the most important. We actively participated in this project on water risk as it provides a useful tool to all financial institutions, and will encourage other commercial banks to focus on this risk.”

Denise Hills, Head of Sustainability and Inclusive Business, Itau Unibanco said: “The world is facing a changing climate. Brazil’s water crisis in 2015 made us more aware about the impacts and possible loss to companies, the economy and environment. We at Itaú Unibanco are proud to participate in the Drought Stress Testing Tool as we can now measure the effects of water-related crises to our portfolios. Knowledge of the risks is the best way to mitigate them. The project is bringing us insights to become even better at socio-environmental risk management in our portfolio.”

Jean Benevides, National Manager of Sustainabilty and Social-environmental Responsibility, Caixa Econômica Federal said: “CAIXA is a public bank and the main financial agent for sanitation in Brazil, especially for water supply. The effects of climate change are already a significant socio-environmental risk to be considered in the analysis of project financing, especially in regions of great vulnerability. At the same time, they also represent an opportunity for new credit operations. Participation in the Drought Stress Testing project is an important step towards developing an effective technical tool that can be incorporated into CAIXA’s analysis and decision-making processes.”

Andrés Albo, Social Committment Director, Citibanamex said: “Social and Environmental Risk Management is one of the pillars of our corporate sustainability strategy. The challenges that climate change brings about, such as drought in Mexico, requires us to be prepared as a financial institution. The great value of this initiative lies in the use of valuable local information to face a global issue.”

Marie Morice, Director of NCFA, said: “The Drought Stress Testing Tool is an example of the collaborative nature of the NCFA’s work: a tool built for the finance sector, with the guidance of the finance sector. By engaging with leading banks in Mexico, Brazil, China and the US, we have developed a tool that can help move natural capital risk analysis closer to mainstream risk management within the banking sector.”

Yannick Motz, Head of the Emerging Markets Dialogue on Finance, GIZ, said: “GIZ has been working with financial institutions and regulators from G20 economies to integrate environmental indicators in lending and investment decisions, product development and risk management. Particularly in the past few years, we have experienced a growing awareness of the financial sector for climate-related risks. The lack of practicable methodologies and tools that adequately quantify, price and assess such risks, however still impedes financial institutions to fully address and integrate them into their decision-making processes. Striving to contribute to filling this gap, GIZ and NCFA initiated this pilot project with the objective to develop an open-source tool that allows banks to assess the potential impact of drought events on the performance of their corporate loan portfolio. The developed framework draws upon RMS’ vast expertise in catastrophe risk modelling central to the insurance industry. For the purpose of this innovative pilot project, RMS adapted well-established models from the insurance sector to build – in a consortium complemented with the Universities of Cambridge and Oxford – a framework and tool. This has been tested by partner financial institutions, which we view key to ensure the tool’s adequacy and practicability for banks as users.”

Eric Usher, Head of UNEP FI, said: “Making the move to a sustainable finance system will require the development of innovative tools such as this. This is the first time drought risk has been assessed in this way, and the involvement of nine forward-thinking banks from around the world proves how serious global financial institutions are becoming about considering the risk from extreme environmental events such as drought.”

Daniel Stander, Global Managing Director, RMS said: “This project has enabled major financial institutions to quantify for the first time the potential systemic risk to their portfolios posed by drought. The tool builds on the advanced modeling techniques which RMS pioneered to manage the complicated exposures of (re)insurance multinationals. To help banks understand the risk to their loan portfolios these capabilities were extended, increasing the resilience to environmental risk of lenders, and the businesses and societies they serve.”

ENDS

For further information, please contact:

Raj Singh, Communications and Content Manager, NCFA
r.singh@natcapfinance.org
info@natcapfinance.org

Nick Ravenscroft, Global PR Lead, RMS
PRTeam@rms.com

Notes to editors

The summary of the findings are published in the ‘Drought Stress Testing – Making Financial Institutions more resilient to Environmental Risks’ report, which can be downloaded here.

About the Natural Capital Finance Alliance (NCFA)

The Natural Capital Financial Alliance (NCFA) was launched at the UN Conference on Sustainable Development (Rio+ 20 Earth Summit) in 2012 by UNEP FI and the UK-based non-governmental organisation, Global Canopy Programme (GCP). It is a worldwide finance led initiative to integrate natural capital considerations into financial products and services, and to work towards their inclusion in financial accounting, disclosure and reporting. Signatory financial institutions are working towards implementing the commitments in the Declaration through NCFA projects. These are overseen by a steering committee of signatories and supporters and supported by a secretariat formed of the UNEP FI and GCP.

About GIZ

The Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH is a global service provider in the field of international cooperation for sustainable development with more than 17,000 employees. GIZ has over 50 years of experience in a wide variety of areas, including economic development and employment, energy and the environment, and peace and security. Our business volume exceeds 2.1 billion euros. As a public-benefit federal enterprise, GIZ supports the German Government – in particular the Federal Ministry for Economic Cooperation and Development (BMZ) – and public and private sector clients in around 130 countries in achieving their objectives in international cooperation. With this aim, GIZ works together with its partners to develop effective solutions that offer people better prospects and sustainably improve their living conditions.

About the Emerging Markets Dialogue on Finance

Under the umbrella of the Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH and commissioned by the German Federal Ministry for Economic Cooperation and Development (BMZ), the Emerging Markets Sustainability Dialogues (EMSD) provide a network of stakeholders and decision-makers from think tanks, multinational corporations, and the financial sector. The Emerging Markets Dialogue on Finance (EMDF) represents one of the three EMSD networks. EMDF brings together high-level emerging market stakeholders from financial institutions, banks and private investors, stock exchanges, central banks, ministries of finance, and international organizations. It strives to enhance the capacity of financial institutions and government bodies in emerging markets to advance the development of a sustainable financial sector. Jointly with our partners, we develop solutions for some of the most pressing challenges in the financial sector, complementing existing processes such as the G20 meetings on a working level.

About the Global Canopy Programme

The Global Canopy Programme is a tropical forest think tank working to demonstrate the scientific, political and business case for safeguarding forests as natural capital that underpins water, food, energy, health and climate security for all. Our vision is a world where rainforest destruction has ended. Our mission is to accelerate the transition to a deforestation free economy. To find out more about our work visit www.globalcanopy.org

About UN Environment Finance Initiative

United Nations Environment – Finance Initiative (UNEP FI) is a partnership between United Nations Environment and the global financial sector created in the context of the 1992 Earth Summit with a mission to promote sustainable finance. Over 200 financial institutions, including banks, insurers and investors, work with UNEP FI to understand today’s environmental challenges, why they matter to finance, and how to actively participate in addressing them.

About RMS

RMS models and software help insurers, financial markets, corporations, and public agencies evaluate and manage catastrophe risks throughout the world. We lead an industry that we helped to pioneer—catastrophe risk modeling—and are the innovators of the RMS(one)® platform, which is transforming the world’s understanding and quantification of risk through open, real-time exposure and risk management.

More than 400 insurers, reinsurers, trading companies, and other financial institutions trust RMS models and SaaS solutions to better understand and manage the risks of natural and human-made catastrophes, including hurricanes, earthquakes, floods, terrorism, and pandemics.

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