Drought stress testing tool launched for banks

Financial institutions and environmental experts from across the globe have partnered in a project to develop a set of environmental risk stress tests that measure the credit worthiness of bank loans. The ‘Drought Stress Testing Tool allows banks to see how incorporating drought scenarios changes the perception of risk in their own loan portfolios.

Based on the catastrophe modelling framework that the insurance industry has used for 25 years, it considers five drought scenarios in Brazil, China, Mexico and the US to model the impact on 19 different industry sectors, the companies in those sectors and the likelihood that they will default on their loans.

The new tool global – designed and developed by a consortium headed by modelling experts Risk Management Solutions (RMS) – has been piloted via stress tests. They were conducted on select, sample corporate lending portfolios of nine international financial institutions: Caixa Econômica Federal, Itaú Unibanco, Santander Brazil, Banorte, Citibanamex, Trust Funds for Rural Development (FIRA), Citigroup, UBS and Industrial and Commercial Bank of China (ICBC), which combined represent more than US$10 trillion in assets.

“This project has enabled major financial institutions to quantify for the first time the potential systemic risk to their portfolios posed by drought,” said Daniel Stander, global managing director, RMS. “The tool builds on the advanced modelling techniques which RMS pioneered to manage the complicated exposures of (re)insurance multinationals.

“To help banks understand the risk to their loan portfolios these capabilities were extended, increasing the resilience to environmental risk of lenders and the businesses and societies they serve.”

The results of the pilot exercise are in a newly-published report, ‘Drought Stress Testing-Making Financial Institutions More Resilient to Environmental Risks’, whose key findings include the following:

  • Extreme droughts could increase loan default losses 10-fold for specific portfolios that are most exposed to the effects of drought.
  • Even when exposed to less extreme drought scenarios, most companies in the analysed portfolios see their credit ratings downgraded.
  • The most affected sectors are water supply, agriculture and, in countries with high reliance upon hydroelectric energy, power generation.
  • Significant impacts are also found in water-dependent sectors such as food and beverage production.
  • Sectors that are less water-dependent but highly sensitive to general economic strength, such as petroleum refining, are also affected by widespread economic impacts of drought.

Linda Murasawa, sustainability head of Santander Brazil commented: “We consider environmental risk management as an irreversible trend in the financial industry. Santander has a long-standing history of considering environmental, social and governance (ESG) in its risk assessments and of promoting sustainable business among its clients.”

Denise Hills, head of sustainability and inclusive business, Itau Unibanco said: “The world is facing a changing climate. Brazil’s water crisis in 2015 made us more aware about the impacts and possible loss to companies, the economy and environment. Participating in this pilot was an excellent opportunity to further foster this agenda and to evolve our understanding of the possible impacts of droughts to our business.”

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