RBI’s Bold Move: Will Indian Banks Pass the Climate Test?
Imagine running a bakery that suddenly faces a severe drought, causing local farmers to fail in supplying your ingredients. Your bakery’s future looks bleak. Now, think about banks dealing with similar climate change challenges on a much larger scale. The Reserve Bank of India’s new draft framework aims to help banks tackle these immense risks head-on. But are they ready for the unpredictable storms ahead? Dive into how banks are gearing up to protect their financial stability against climate change’s growing threats and discover if they can weather the storm.
Have you ever wondered how a bank deals with the ever-changing risks of climate change? Imagine running a bakery that relies on local farmers for ingredients. Suddenly, a severe drought hits, causing crops to fail. The farmers can’t supply you anymore, and your bakery’s future looks uncertain. This is the kind of challenge banks face with climate change, only on a much larger scale.
The Reserve Bank of India (R.B.I) has taken a bold step by introducing a draft climate risk disclosure framework to help Indian banks and financial institutions tackle these challenges head-on. They need to disclose both physical and transition risks related to climate change. This means they have to evaluate how vulnerable their assets are to natural disasters like floods and storms (physical risks) and to changes in regulations, technology, and consumer behavior as the world shifts to a low-carbon economy (transition risks). Imagine if your bakery had to suddenly switch to new, expensive eco-friendly ovens because of new regulations — this is similar to the transition risks banks must consider.
Climate change is becoming one of the biggest emerging risks for financial institutions. United Nations Secretary-General António Guterres has warned that climate disasters are devastating economies worldwide. To combat these effects, banks need to implement sound practices and action plans. The RBI’s framework aims to enhance transparency and accountability, empowering banks to address climate-related risks proactively. This is crucial because climate change can lead to economic damage, but predicting its exact timing and extent is almost impossible.
For banks, physical risks can directly impact their loan portfolios. Imagine a bank has given out many loans for homes and farms. If a severe flood hits, causing widespread damage, many borrowers might default on their loans, increasing the bank’s risk. Transition risks, on the other hand, come from the economy’s shift towards net-zero emissions. If a sudden increase in carbon prices happens, companies might struggle to pay their loans back, leading to higher default rates. This is akin to your bakery having to cope with sudden spikes in ingredient costs due to new environmental policies.
The Basel Committee on Banking Supervision (BCBS) has highlighted that banks are exposed to climate change through various channels. They urge banks to take a dynamic approach to developing their risk management capacities. In December 2022, the BCBS issued responses to frequently asked questions, clarifying how banks can measure climate-related financial risks. They emphasize that banks should include climate risk in their assessment of credit and market risks and monitor them continuously. Although data limitations exist, banks are encouraged to improve their capacity to assess these risks as more data becomes available.
The RBI’s draft disclosure framework aligns Indian banks’ climate policies with international standards. It mandates disclosures in governance, strategy, risk management, and metrics and targets. Banks must have structures and processes for board and management oversight on climate risk and opportunities. They need to describe the impacts of climate-related risks and opportunities on their business strategy and financial planning. Additionally, banks should integrate climate risks into their overall risk management frameworks. Metrics and targets will help banks specify methods and objectives to assess and manage these risks.
Currently, the concept of climate risk assessment is relatively new for Indian banks. Only a few companies among the top 200 firms on the Bombay Stock Exchange voluntarily disclose their climate data and preparations. The RBI is encouraging banks to popularize the use of CO2 equivalents as a universal measurement unit for greenhouse gases. Banks are also expected to track financed emissions, which are the emissions from the companies they lend to or invest in. This helps them understand their indirect impact on the environment.
Real-life examples help illustrate these complex topics. For instance, banks can track the carbon footprint of the companies they lend to by looking at indicators like CO2 emissions and carbon intensity (the ratio of CO2 emissions to a company’s revenues). This is similar to how your bakery might track the quality and sourcing of its ingredients to ensure sustainable practices. Understanding the carbon intensity of high-risk industries like cement, metal, and power helps banks map their exposure to fossil fuel-intensive sectors and link it to climate change risk.
Investors and market participants are increasingly paying attention to climate change. Transparency and quality disclosure can enhance investors’ and depositors’ confidence. Globally, stakeholders use the Environmental, Social, and Governance (E.S.G) score to assess a company’s sustainability. A higher E.S.G score indicates better sustainability performance, much like how your bakery might earn a higher rating for using organic and locally sourced ingredients. This positive perception can ultimately increase a firm’s value.
Studies have shown that banks want to project themselves as good corporate citizens, especially when they operate in environmentally friendly countries and have strong financial positions. However, the picture is less clear when it comes to implementing rigorous carbon disclosure. Coordinated efforts by regulators, banks, and their counterparties are needed to identify, assess, measure, monitor, and manage climate-related financial risks. This includes performing stress tests under various climate scenarios to assess potential losses.
Banks must gear up their climate risk assessment and governance initiatives to meet the RBI’s new disclosure requirements. Proper risk assessment and disclosure frameworks are essential to measure and understand climate change risks. Setting time horizons for climate risk planning in line with the bank’s business goals is crucial. For corporate loan books, banks need to examine the direct relationship between financial factors, credit ratings, and climate ratings like E.S.G scores.
Metrics such as CO2 emissions to total sales or total assets for firms and sectors, and exposure to high CO2-intensive or low E.S.G sectors, help banks conduct risk analysis more objectively. Climate value-at-risk (climate-VaR) enables banks to integrate different climate scenarios into their credit or investment portfolios and perform loss analysis. This way, banks can develop robust climate risk management capabilities.
As banks navigate these new waters, it’s essential to keep asking, how can financial institutions better prepare for the unpredictable nature of climate change? And what steps can other industries take to follow suit in safeguarding their futures? The answers to these questions will shape the resilience of our economies in the face of a changing climate.
References
BCBS (2022): “Basel Committee Clarifies How Climate-related Financial Risks May be Captured in the Existing Basel Framework,” BIS press release, December.
Bandyopadhyay, A. (2024). Economic and Political Weekly, 59(№28).
Caby, Jérôme, Ydriss Ziane and Eric Lamarque (2020): “The Determinants of Voluntary Climate Change Disclosure Commitment and Quality in the Banking Industry,” December, Technological Forecasting and Social Change, 161(8): 120282 December 2020161(8): 120282 DOI: 10.1016/j.techfore.2020.120282.
RBI (2024): “Draft Disclosure Framework on Climate-related Financial Risks, 2024,” 28 February.
Sinha, A and S Bhanvadia (2024): “Climate Stress Testing and Scenario Analysis: Navigating Uncharted Waters,” RBI Bulletin, January, pp 137–45.
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