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ABSTRACT
As extreme weather events continue to impact every continent and the world moves towards establishing a lower-carbon economy, the banking industry is expected to incorporate climate risk into their risk management practices. Climate change poses significant risks to bank loan portfolios through increased physical and transition risks. This study systematically analysed the literature to identify effective strategies for managing these risks. Our findings reveal that climate-related events can lead to substantial loan defaults and credit losses. To mitigate these impacts, banks can integrate climate risk into their risk management frameworks, adopt sustainable lending practices, and diversify their portfolios. Some banks have already implemented measures to mitigate climate risk through insurance policies, while others are incorporating sustainability criteria into their lending practices, such as financing green projects. By proactively addressing climate risks, banks can protect their portfolios, enhance financial resilience and contribute to a low-carbon economy.
Keywords:
Climate Risk; Green Financing; Loan
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Introduction
Climate change is a defining issue of our time, posing significant threats to various sectors, including the financial industry. According to Nyberg & Wright (2022), climate change is causing increasingly frequent and severe heatwaves, fires, storms, droughts, rising sea levels, warming of the ocean, and increased geopolitical tensions and conflicts. Such extreme weather events can have a significant impact on firm's financial performances, affecting its revenues, expenditures, assets, and costs of capital. Battiston et al. (2017) highlight that banks are exposed to climate change by providing capital to firms with high physical or transition risks, emphasizing the need for financial institutions to consider climate-related risks in their lending and investment strategies. Physical risks refer to shocks related to physical changes in the climate, while transition risks arise due to changes in climate-related regulatory policies (e.g., the introduction of a carbon tax) or litigation. Both types of risk can increase the default probability of exposed firms, which in turn increases the riskiness of banks' lending portfolios (Martini et al. 2023). Climate-related risks are challenging for banks as they are difficult to identify, price, and hedge among other reasons because of their systematic nature, insufficient disclosures by firms, and a lack of hedging instruments (Krueger et al. 2020).
Banks have realised in recent years that climate risks have the potential to strand...