When I first heard a senior risk officer at a European lender say “we don’t really know,” it had nothing to do with sovereign debt or interest rates. It had to do with flooding. a particular river in a particular area where the bank had a sizable mortgage book.
With a half-smile and a shrug, he moved on. I learned more about the true location of climate risk within the financial system from that shrug than from any speech made by a central banker.
| Field | Detail |
|---|---|
| Subject of focus | Physical and transition climate risks on bank balance sheets |
| Primary regulator pioneering the framework | Bank of England (introduced the three-risk taxonomy in 2015) |
| Key data source for emissions disclosure | Carbon Disclosure Project (CDP) |
| Banks studied in recent panel research | 147 banks across 37 countries (2011–2020) |
| Share of EU banks flagged as highly exposed | Roughly 15 percent of 46 surveyed European banks |
| Landmark policy event | Paris Agreement, COP21, December 2015 |
| Coalition pledge year | 2019 — 130 banks aligned with climate targets |
| Earliest financial-sector environmental initiative | UNEP FI, launched in 1991 |
| Risk types tracked | Physical, transition, liability |
| Reported direction of impact | Transition risk: positive on performance; Physical risk: negative |
For the past ten years, banks have insisted that they take climate risk seriously. To be fair, a lot of them do, at least the portion that neatly fits into a spreadsheet. In board meetings, transition risk—the kind associated with carbon prices, policy changes, and stranded assets—has practically become fashionable. Strangely enough, it is profitable, quantifiable, and modelable. Transition risk actually correlated with better performance and faster lending growth, according to a recent study that examined 147 banks in 37 countries. This was partially because regulations encouraged institutions to create greener portfolios, which the markets subsequently rewarded.
Physical danger is an entirely different matter. Heat domes, floods, wildfires, and the gradual salting of coastal farmland don’t fit neatly into a regression. Physical risk appears to be having an increasing impact on bank performance and loan growth, according to the same studies.
However, the majority of stress tests continue to view extreme weather as a tail event that should be noted in a footnote rather than factored into a mortgage. Walking through any major financial district gives the impression that the buildings themselves are better equipped to withstand climate shocks than the loan books they contain.
A portion of the issue is cultural. Climate cycles were not taught to bankers, but credit cycles. Even though the cash flow damage may be greater, a drought that ruins California’s almond harvest doesn’t appear in a quarterly model the way a missed bond payment does. For their part, regulators have relied significantly on disclosure frameworks such as the Carbon Disclosure Project and the TCFD’s recommendations; however, disclosure and measurement are not the same. Even if you publish an exquisitely crafted sustainability report, you won’t know how a Category 5 hurricane would affect your Miami commercial real estate exposure.
It’s difficult to ignore the asymmetry as you watch this play out. Markets nodded courteously when the European Central Bank identified climate risk as a threat to balance sheets. In 2015, the then-governor of the Bank of England cautioned that mispricing could cause the system to become unstable, but capital requirements remained largely unchanged. Things moved forward thanks to the Paris Agreement. The 2019 coalition of 130 banks followed suit. However, the underlying machinery, which includes risk-weighted assets, internal models, and supervisory review, continues to handle a flooded warehouse in the same manner as it handles a delayed invoice.
Additionally, there is a more subdued problem that is rarely discussed aloud. Under climate stress, larger banks seem to experience more financial instability rather than less, especially those with stakeholder-oriented governance. It may be incorrect to assume that large institutions are better insulated. Simply put, their portfolios are more exposed to the actual economy, which is the real source of physical risk.
It’s still unclear if regulators will eventually close the gap. There are the tools. Despite its flaws, the data does exist. The willingness to acknowledge that the existing models undervalue something significant is what’s lacking. Until then, every big bank has a position on climate change that it hasn’t fully acknowledged, and the rest of us are, in a way, holding it with them.