Banks may need additional provision requirement for climate change

Banks may need additional provisioning requirements due to climate change-induced GDP shock under different plausible scenarios, according to the central bank.

The Bangladesh Bank conducted and published a scenario-based climate stress testing on the banking sector on Monday (28 April) to identify and measure the plausible risks to financial stability arising from the adverse impact of climate change. 

The additional provisioning requirement estimation was made for 2025, 2030 and 2035 considering March 2024 as base period. 

The study used GDP projection data under various climate scenarios published by the Network for Greening the Financial System (NGFS). 

The report used satellite models to derive the association between macro variables and the credit risk of banks through econometric analysis. 

To calculate the provisioning requirement in different climate scenarios, five sample bank-specific capital engines were used. 

The selected banks hold approximately 30%  of the total banking sector assets. 

The report revealed valuable insights into the current state of the financial system, particularly regarding how banks perceive the overarching impact of climate change. 

The developed framework can be used as a policy tool to improve the readiness of the banks to manage the risks associated with climate change. 

The main objectives of the research are to identify the impact of macroeconomic variables, particularly GDP, on the credit risk of banks and explore how different hypothetical GDP projections in various climate scenarios adversely affect banks' loan loss.

The report mentioned that the banking sector would incur more loss over the projected period as compared to the base period in various climate scenarios. 

The estimated Loan Loss Reserves (LLRs) for the overall banking sector under all the climate scenarios and conditions are consistently higher for the projected years of 2025, 2030, and 2035 than the actual LLR recorded in 2024. 

Furthermore, the estimated additional LLRs for the overall banking sector due to climate shock follow an upward trend over the projected periods. 

The impact of physical climate risks on LLR under high chronic physical damage conditions would be comparatively higher than the impact under medium chronic physical damage conditions. 

Among the climate scenarios, the high-ambition scenario, which is, the below 2°C scenario with high chronic physical damage condition, leads to the most significant increases in the loan loss reserve in the long term (2035). 

The higher estimated LLRs under various climate scenarios emphasize the need for robust provisioning strategies to effectively manage potential climate-driven impacts for the banking sector.

Banks should consider the potential effects of climate-related risk factors when formulating and executing their business strategies. This includes evaluating the resilience of their business models to significant climate-related financial risks across different time frames leveraging climate stress testing. Based on the findings of this report, some supervisory measures are highlighted accordingly. 

At this stage, instead of imposing additional capital requirements on banks, Bangladesh Bank prioritized building awareness within the financial system regarding the risks associated with climate change. 

To strengthen the resilience of the Bangladesh financial system against climate risks, Bangladesh Bank may take proactive steps to implement a robust methodology for climate risk assessment and adopt an updated climate stress testing framework.