Understanding the principles for climate-related financial risk management for large banks begins with data
How prepared is the U.S. market for the consequences of physical climate risk?
The Federal Reserve Bank (FRB) posed that question to six of the top U.S. banks to better understand the financial stability of the country’s mortgage loan ecosystem.
What they found was that even the biggest banks in the nation — Bank of America Corporation; Citigroup Inc.; The Goldman Sachs Group, Inc; JPMorgan Chase & Co.; Morgan Stanley; and Wells Fargo & Company — operate with uncertainty when determining how to identify, estimate, and manage the magnitude of climate-related risk.
The FRB’s Pilot Climate Scenario Analysis Exercise highlighted participants’ challenges surrounding the measurement of climate-related impacts, particularly the existing gaps in banks’ ability to quantify real estate exposure and insurance risk management information.
The identification of these gaps underscores the need for detailed, data-driven understanding when measuring the evolving impact of climate risk.
Measure + Model + Mitigate
=
The formula to address climate-related risk.
“We applaud the efforts of the FRB and the participating banks,” said CoreLogic’s ESG, climate risk, natural hazard, and spatial solutions expert George Gallagher. “This Climate Scenario Analysis shined a light on the need for processes and data assets that may or may not exist. Understanding the impact of climate change on the financial ecosystem here in the U.S. requires focus and commitment, starting with the data.”
Acquiring and maintaining the data necessary for the accurate assessment of climate-related financial risk will be a challenge for banks, but it is possible. Resilience begins with access to consistent, granular data that can quantify losses for multiple climate-driven perils across a variety of climate scenarios.
Get the Full Picture to Plan for Climate-Related Financial Risk
Building a more secure and resilient financial foundation that considers the impacts of climate risk is a serious, impending challenge for both banks as well as for the U.S. mortgage ecosystem.
During this FRB study, participants reported data gaps related to real estate exposure and insurance risk management. All participants reported data gaps related to insurance, including replacement cost value.
These shortcomings in data further complicate the already nuanced challenge of measuring the long-term effects of climate risk. With incomplete datasets and uncertainty in risk modeling, it will continue to be challenging to quantify the impact of climate-related risk and plan accordingly.
“We have said that this would be a heavy lift for banks, and the summary validates this expectation,” explains Gallagher. “The diversity of the outcomes suggests inconsistent definitions, data/granularity, and processes, which ultimately leads to no comparability.”
The banks participating in this study noted that they intend to incorporate climate scenario analysis into their risk-management processes over time by investing in the required data and models needed to quantify — and then mitigate — this risk.
Although a simple answer, it is not an easy one.
“Understanding the impact of climate change on the financial ecosystem here in the U.S. requires focus and commitment, starting with the data.”
— George Gallagher, CoreLogic’s ESG, climate risk, natural hazard, and spatial solutions expert
Enhancing Outcomes With Better Data
Addressing climate risk requires climate risk software and processes to achieve three distinct steps:
- Accurate measurement
- Probabilistic modeling
- Potential mitigation actions
The first step may be the most nuanced. Measuring the future consequences of climate risk requires comprehensive, granular property data that provides an accurate view of climate and exposure.
Most study participants “reported data gaps around building characteristics and largely relied on national or regional ‘default’ property characteristics from their vendors.”
While data is abundant, it is imperative that quantity is not equated with quality. That is why quality property data is at the heart of building resilient strategies for the unpredictable challenges posed by a changing climate.
CoreLogic’s deep property data archives are built with an understanding of the importance of complete, reliable, consistent, and accurate data for gleaning the insights that will help define financial futures.
From location intelligence to climate and hazard risk, CoreLogic data looks at unique property identifiers to pinpoint the physical risk at a parcel level. By making sure that each unique property is assessed for its individual characteristics, financial institutions and other stakeholders can ensure that risk is quantified with unmatched granularity and that decisions are made with the confidence and accuracy needed to improve outcomes for everyone.
Granularity Matters. So Does Scale.
The second notable finding from this study is that all participants depended on existing model risk-management frameworks relying on the assumption that historical relationships between inputs and outputs will remain viable as the climate changes.
The study showed that this approach resulted in challenges including “limited data, lack of back-testing capabilities, non-linear risks, scenario horizon, heavy reliance on judgement, limited reliability of model output, and time constraints.”
Incorporating forward-looking catastrophe models is critical to the proper evaluation of financial risk. In support of providing relevant, specific, and useful information to analyze future physical risk, CoreLogic’s Climate Risk Analytics focuses on property-level physical and financial insight when looking at nine specific peril impacts across a variety of climate scenarios.
In addition to analyzing impacts across a range of perils, CoreLogic integrates best-in-class climate modeling with our third-generation, high-definition Climate-Coupled-Catastrophe Models™. The inclusion of these models into Climate Risk Analytics covers comprehensive climate change physical risk measures for wildfire, hurricane, storm surge, inland flood, severe convective storm, winter storm, and earthquake.
Whether it’s property location, first-floor height, square footage, renovations, municipal regulatory data, or reconstruction costs, Climate Risk Analytics offers a comprehensive model of the future at an unprecedented level of detail.
Where Does Insurance Fit Into the Conversation?
Banks also need to understand the mitigating effects of insurance on climate-related losses. Although insurance is not a panacea for the pressures that climate risk puts on the financial institutions underpinning U.S. real estate and the housing market, it is nevertheless an important consideration.
Banks rely on insurance companies and third-party appraisers to estimate the replacement costs of mortgage collateral and provide a cushion in the event of a natural disaster.
To accurately assess all possible climate risks to collateral — whether for regulators, for insurance purposes, or for understanding idiosyncratic risk — banks need insight into every property in their portfolios as well as the ability to model climate perils into the future.
Enterprise Risk Management Begins With Understanding
It is only once the consequences of climate risk are modeled and understood that stakeholders can take action and design long-term resiliency and mitigation plans to protect themselves and U.S. property owners.
Proactivity is the key to laying the groundwork for resilience in the face of climate challenges and future regulatory requirements.
The findings from the Pilot Climate Scenario Analysis Exercise are only the initial step in the pursuit of resilience and mitigation. In fact, this pilot study emphasizes that there is still ample room for banks to build their understanding of risk and loss as correlated with climate-driven perils.
But developing an understanding of climate-related risk is not unique to financial institutions. From publicly traded companies and telecom infrastructure projects to chief risk officers and compliance professionals, preparing for the future means having accurate and true datasets and models, reducing risk levels, addressing insurance gaps, and taking advantage of available analytic tools.
We all must face these climate challenges head on using the resources available. In the end, it will be our willingness to make the necessary changes today that will determine our ability to flourish in the future.
Looking to discuss your climate-related risk management and modeling needs?
Climate Risk Analytics
©2024 CoreLogic, Inc. All rights reserved. The CoreLogic content and information in this blog post may not be reproduced or used in any form without express written permission. While all of the content and information in this blog post is believed to be accurate, the content and information is provided “as is” with no guarantee, representation, or warranty, express or implied, of any kind including but not limited to as to the merchantability, non-infringement of intellectual property rights, completeness, accuracy, applicability, or fitness, in connection with the content or information or the products referenced and assumes no responsibility or liability whatsoever for the content or information or the products referenced or any reliance thereon. CoreLogic® and the CoreLogic logo are the trademarks of CoreLogic, Inc. or its affiliates or subsidiaries. Other trade names or trademarks referenced are the property of their respective owners.
