Drought may present a range of direct and indirect risks to financial institutions, impacting the long-term sustainability of their investment and lending.
However, a robust tool which stress tests investment and lending portfolios for the environmental risk of drought had not previously been developed. Without quantifying the impact of natural capital risks on portfolios across a range of potential scenarios, it would not be possible to make fully informed investment decisions.
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 report published in March 2017, ‘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.
Since the Drought Stress Testing Tool was launched, with some of the biggest financial institutions around the world, at events in Sao Paulo, Beijing, Mexico City, New York and London, numerous financial institutions have contacted the NCFA directly to request access. By working closely with the finance sector in this way, the NCFA will continue to help financial institutions integrate natural capital considerations into their risk management and, ultimately, lending, investment and insurance practices.