Addressing Climate Risk in Indian Banks: Strategies for Mitigation and Resilience

The financial sector faces a dual challenge: recalibrating operations and strategies to support the green transition while bolstering resilience against the increasing vulnerability to adverse climate events. This approach is crucial to safeguard financial stability. Estimates suggest that India requires at least 2.5% of its GDP annually in green financing to address infrastructure gaps exacerbated by climate events. The financial system must mobilize and reallocate resources effectively to contribute to the country’s net-zero target. However, climate stress-tests reveal that public sector banks (PSBs) in India may be more vulnerable than private sector banks (PVBs).

Understanding Climate Risk

Climate risk encompasses the potential adverse effects of climate change on natural and human systems. As greenhouse gas emissions increase, the frequency and intensity of climate-related events such as extreme weather, rising sea levels, and changing precipitation patterns escalate. These changes pose significant risks to ecosystems, human health, and economies worldwide. Indian banks are not immune to these impacts, which threaten their asset quality, operational efficiency, and overall financial health.

In 2022, India experienced extreme weather events on 314 of 365 days. Despite this, major Indian banks have been unprepared to confront climate risks, according to a report by Climate Risk Horizons. This analysis, covering the year 2022-23, indicates significant gaps in the preparedness of the Indian banking sector to measure, manage, and mitigate climate risks. The study assessed the climate preparedness of India’s 34 largest banks, with a combined market cap of Rs 29.5 trillion.

Key Findings

1. Inadequate Preparedness: Despite the accelerating impacts of climate change, significant gaps remain in the Indian banking sector’s ability to handle climate risks. This includes a lack of clear policies and implementation plans for funding climate-related areas.
2. Discrepancies in Performance: Yes Bank, HDFC Bank, and Axis Bank are the top performers in climate-risk preparedness, with some banks beginning to disclose emissions indirectly caused by their activities. However, Yes Bank is the only bank to measure its financed emissions, but only for the electricity sector.
3. Lack of Scenario Analysis: No bank has undertaken climate-related scenario analyses, despite the increasing frequency of extreme weather events.
4. Public Sector Challenges: Public banks are particularly failing to finance India’s energy transition adequately, with public sector banks accounting for less than 8% of total financing for the renewable energy sector. Only 10 banks have disclosed their green financing activities.

Risks Posed by Climate Change

1. Physical Risks: These arise from direct impacts such as extreme weather events, rising sea levels, and shifts in precipitation patterns. India’s diverse geography and large agricultural sector make it particularly vulnerable.
   • Extreme Weather Events: Increased frequency and intensity of events like floods, droughts, and cyclones cause extensive damage to property and infrastructure, leading to higher default rates on loans.
   • Agricultural Sector Vulnerability: Climate variability directly affects crop yields, impacting the repayment capacity of farmers and increasing the risk of non-performing assets (NPAs) in banks with significant exposure to agricultural loans.
2. Transition Risks: These involve economic and policy shifts needed to mitigate climate change and transition to a low-carbon economy.
   • Regulatory Changes: Evolving regulatory frameworks promoting sustainability can impact the financial viability of carbon-intensive sectors like coal, oil, and gas.
   • Technological Disruption: Advancements in renewable energy and energy efficiency can render traditional energy investments obsolete, creating the risk of stranded assets.
3. Financial Stability and Asset Quality: The Reserve Bank of India (RBI) has expressed concerns over the financial stability risks posed by climate change. As the frequency of climate-related events increases, so does the potential for widespread defaults, affecting the asset quality of banks. A surge in NPAs can strain banks’ capital reserves, reducing their ability to lend and impacting overall economic growth.
4. Operational Risks:Operational risks also emerge as climate change affects the day-to-day functioning of banks. Branches in flood-prone areas face physical damage, leading to interruptions in banking services. Additionally, banks must invest in resilient infrastructure to safeguard their operations, incurring additional costs.

Strategic Responses and Risk Mitigation

Indian banks are increasingly recognizing the need to integrate climate risk into their risk management frameworks. Key strategies include:

1. Enhanced Risk Assessment: Developing sophisticated models to assess climate risk exposure, including stress testing and scenario analysis.
2. Green Financing: Financing sustainable projects and businesses, with green bonds and loans for renewable energy projects gaining popularity.
3. Policy Advocacy and Collaboration: Engaging with policymakers to shape regulations supporting climate risk mitigation and collaborating with international organizations for best practices and innovative solutions.

Recommendations for Indian Banks

To effectively manage and mitigate climate risks, Indian banks should adopt a strategic, multifaceted approach:

1. Conduct Comprehensive Risk Assessment

A foundational step in mitigating climate risks is to conduct thorough risk assessments. Banks need to:

• Evaluate Exposure: Assess the bank’s exposure to both physical and transition risks. This involves identifying vulnerable assets, clients, and geographies.
• Scenario Analysis: Use climate scenarios to explore potential future risks under various climate pathways, aiding in understanding the range and magnitude of potential impacts.

2. Strengthen Governance and Strategy

Integrating climate risk into the bank’s governance structure and strategy is crucial:

• Board Oversight: Ensure the board of directors has oversight of climate risk management. This includes setting policies and reviewing climate-related risks and strategies regularly.
• Strategic Integration: Incorporate climate risk considerations into the bank’s overall business strategy. This means aligning business goals with sustainability and climate resilience objectives.

3. Enhance Risk Management Framework

Developing a robust risk management framework is essential for proactively addressing climate risks:

• Climate Risk Management Framework: Establish a comprehensive framework to identify, assess, manage, and monitor climate-related risks. This should be integrated into the bank’s overall risk management processes.
• Enhanced Due Diligence: Implement rigorous due diligence processes for clients and investments with high exposure to climate risks, ensuring these are adequately mitigated or managed.
• Stress Testing: Conduct regular stress tests to evaluate the bank’s resilience to climate-related shocks, helping to identify vulnerabilities and inform mitigation strategies.

4. Leverage Data and Analytics

Accurate data and advanced analytics are critical for understanding and managing climate risks:

• Improve Data Quality: Gather reliable and comprehensive data on climate risks and their financial impacts. This includes environmental data, market data, and client-specific information.
• Utilize Advanced Analytics: Employ advanced analytics, including AI and machine learning, to model and predict climate risks. This helps in making informed decisions and developing effective risk mitigation strategies.

5. Ensure Regulatory Compliance

Staying compliant with evolving climate-related regulations is vital:

• Stay Updated: Keep abreast of new and emerging regulations and guidelines related to climate risk. This includes international frameworks like the Task Force on Climate-related Financial Disclosures (TCFD).
• Disclose Climate Risks: Enhance transparency by disclosing climate risks and mitigation strategies in line with regulatory requirements and best practices. This builds trust and credibility with stakeholders.

6. Promote Sustainable Finance

Supporting sustainable finance initiatives can mitigate climate risks and support global climate goals:

• Green Financing: Increase financing for projects and companies that contribute to environmental sustainability. This includes renewable energy projects, energy efficiency initiatives, and sustainable agriculture.
• Develop Green Products: Offer financial products that support sustainability, such as green bonds, sustainable loans, and ESG-linked investment products.

7. Enhance Operational Resilience

Ensuring the bank’s operations can withstand climate impacts is critical for long-term resilience:

• Upgrade Infrastructure: Enhance physical infrastructure and operational systems to be resilient to extreme weather events and other climate impacts.
• Business Continuity Planning: Integrate climate risk considerations into business continuity and disaster recovery planning to ensure the bank can maintain operations during and after climate-related disruptions.

8. Engage with Stakeholders

Collaboration and communication with stakeholders are key to managing climate riskseffectively:

• Stakeholder Engagement: Engage with clients, investors, regulators, and civil society to understand their concerns and expectations regarding climate risk management.
• Educate and Train: Provide training and resources to staff to build awareness and capability in managing climate risks. This includes ongoing education on climate science, risk management techniques, and regulatory requirements.

9. Monitor and Report Progress

Continuous monitoring and transparent reporting are essential for effective climate risk management:

• Regular Monitoring: Continuously monitor climate risk exposures and the effectiveness of mitigation measures. This includes tracking changes in risk profiles and emerging threats.
• Report Progress: Regularly report on climate risk management efforts and progress towards sustainability goals. This includes publishing detailed reports and updates for stakeholders.

10. Foster Innovation and Collaboration

Innovation and collaboration can drive effective climate risk mitigation:

• Invest in R&D: Support research and development for innovative solutions to climate risks. This includes developing new financial products, risk management tools, and sustainability initiatives.
• Collaborate with Peers: Join industry initiatives and collaborate with other banks and financial institutions to share best practices and drive collective action on climate risks.

Conclusion

The impacts of climate change on Indian banks are profound and multifaceted, affecting asset quality, operational stability, and financial health. As climate risks become more pronounced, banks must adopt proactive measures to mitigate these risks. By implementing comprehensive strategies, banks can effectively manage climate risks, safeguard financial stability, and contribute to global efforts to combat climate change.