It is important to remain pragmatic when considering how to incorporate climate-change considerations and ESG factors into business strategy and risk-management activities. The climate issue is a highly sensitive one. Stakeholders want action and banks are feeling the pressure to respond. Rather than rushing their response, the best strategy is comprehensive, adequate preparation: a bank can create a value-focused road map setting out an agenda fitted to its circumstances and considering both the regulatory and physical status quo. Once the road map is enacted, banks should adopt a standardized approach to implementation by ensuring that investments are tied to areas of business value by meeting external expectations, facilitating finance, and offering downside protection.
To develop a comprehensive approach to risk management, McKinsey pinpoints three key steps that can be reached in four to six months.
1) Define your strategic ambition
Competent climate-risk management should be based on a committed strategy. Individual banks must be sure about how they want to act and identify the industry sectors and client segments where they can add the most value. They should also put into place governance frameworks for climate risk—frameworks that include the use of dedicated senior personnel, as well as a minimum standard for reporting up and down the business.
2) Build the foundations
As quickly as they can, banks should pinpoint the tools, processes, and methodologies they will need to effectively manage climate risk. This involves ingraining climate factors into credit and risk framework. This also includes integrating environmental, social, and governance or ESG factors into the business’ strategy and guidelines. Stress tests and scenario analyses will be pillars of supervisory frameworks and should be considered necessary capabilities. Outcomes should be hardwired into disclosure and reporting frameworks. Finally, like most sectors, banking does not yet have the climate-risk resources it needs. The industry must therefore accumulate skills and buy or build relevant analytics, IT, and data.
3) Construct a climate-risk-management framework
Banks must aim to embed climate-risk factors and ESG factors into decision making across their front- and back-office activities and for both nonfinancial and financial risks. A significant hurdle will be data, which is needed to understand the fundamentals of climate change as well as the impact it will have on activities like client-relationship management, pricing, and credit risk. However, a dearth of data should not become a barrier to getting started. Banks should measure – as far as possible – climate exposures at several levels, including by portfolio, sub portfolio, and even transaction. This will enable the creation of detailed reports of specific situations where necessary and heat maps. In corporate banking, this kind of measurement and reporting might support individual companies’ climate-adjusted credit scorecards. Banks may then assign specific risk limits. In fact, some banks have already moved to integrate these types of approaches into their loan books.
Banks play a crucial role in economic development that now includes managing the transition and physical risks of climate change. The task is complex, and the models and assumptions needed to align the business with climate priorities will inevitably be refined over time. Yet, as the climate continues to change, banks will need to have these types of priorities at the forefront.
