Physical Risk Case Study – Impact of Flooding on a Bank’s Liquidity

As climate change accelerates, physical risks like flooding are becoming more frequent, severe, and financially material. For banks, these are not just operational disruptions — they can trigger liquidity stress, asset impairments, and even off-balance sheet losses.

Flooding is no longer a remote environmental concern. It is now a financial risk event that can reverberate through a bank’s entire balance sheet, challenging risk teams, ALM desks, and executive committees alike.

Liquidity at Risk: How Floods Dry Up Cash

1. Surge in Withdrawals

   Customers in affected areas often panic and withdraw funds, especially from branches perceived to be at risk.

   • CASA balances drop

   • Liquidity Coverage Ratio (LCR) declines

   • Short-term wholesale funding needs increase

2. Loan Repayment Delays

   Retail and MSME customers in flood-affected areas may defer or default on repayments.

   • Mismatch between cash inflows and outflows

   • Temporary or permanent loan modifications

   • Strain on projected cash flow schedules

3. Branch and Infrastructure Disruption

   Physical branches, ATMs, and even digital platforms may go offline in impacted areas.

   • Payment delays

   • Settlement backlogs

   • Spike in operational liquidity needs

4. Collateral Value Erosion

   When mortgaged properties, warehouses, or inventory are damaged by floods:

   • Banks face markdowns in collateral value

   • Margin or repo eligibility is affected

   • Emergency funding access becomes constrained

5. Market Confidence and Interbank Pressure

   Markets penalize institutions perceived to be exposed or ill-prepared.

   • Stock price volatility

   • Reduced access to interbank markets

   • Potential rating downgrades

Balance Sheet Disruption: Assets, Liabilities & Off-Balance Sheet Items

Asset-Side Risks

• Loan Book Deterioration

  Floods disrupt borrower incomes, leading to higher delinquencies and NPAs, especially in sectors such as agriculture, housing, and small businesses.

• ECL Provisions Spike

  Expected Credit Loss (ECL) models under IFRS 9 may force stage migration of affected loans, increasing provision requirements and reducing profitability.

• Collateral Write-downs

  Properties and assets used as collateral lose value when damaged, weakening the secured position and raising Loan-to-Value (LTV) ratios.

• Asset Impairment

  Bank-owned physical assets (e.g., branches, equipment) damaged by floods may require write-downs or impairments.

Liability-Side Risks

• Volatile Deposit Base

  Withdrawals may increase and banks may have to rely more on costlier wholesale funding, driving up liability costs.

• Refinancing Becomes Riskier

  Flood-related instability can raise perceived institutional risk, leading to higher funding costs or reduced access to capital markets.

• Triggering of Contingent Liabilities

  Guarantees, letters of credit, and other contingent exposures may be invoked due to defaults, converting off-balance sheet items into on-balance sheet liabilities.

• Insurance Premiums and Claims Payables

  For banks with insurance arms, flood-related claims can lead to large outflows and long-term underwriting losses.

• Reputation Risk-Induced Depositor Flight

  Weak climate risk management can cause depositor churn, especially among institutional or ESG-sensitive clients.

Off-Balance Sheet Risks

• Undrawn Credit Lines

  Customers may draw down on pre-approved facilities (e.g., OD/CC limits), causing unplanned liquidity outflows and higher capital requirements due to CCF activation.

• Invocation of Guarantees

  Performance or financial guarantees for flood-impacted projects can be triggered, leading to cash outflows and increased capital consumption.

• Securitization & Risk Retention

  Loans in securitized pools may become delinquent. First-loss tranches retained by the bank absorb losses, impacting capital and provisions.

• Derivative & Hedging Triggers

  Floods can cause FX/IR derivative MTM losses, collateral calls due to volatility, and downgrades in counterparties or underlying sectors.

What Should Banks Do?

To build resilience, banks must embed flooding and other physical risks into their liquidity, ALM, and capital planning frameworks.

1. Embed Climate Risk into Risk Frameworks

   • Integrate physical and transition risks into ICAAP, ILAAP, and risk appetite statements

   • Conduct climate-adjusted stress tests and scenario analyses

2. Enhance Geographic and Sectoral Risk Mapping

   • Identify flood-prone hotspots using geospatial and historical data

   • Monitor exposures by region, sector, and borrower sensitivity

3. Upgrade Credit Risk and ECL Models

   • Incorporate climate variables into PD, LGD, and EAD frameworks

   • Use forward-looking indicators from meteorological and socio-economic data

4. Strengthen Liquidity Buffers and Contingency Planning

   • Maintain additional buffers for high-risk geographies/sectors

   • Update Contingency Funding Plans (CFPs) with climate-linked scenarios

5. Improve Collateral Management

   • Apply dynamic haircuts for collateral in flood-prone areas

   • Ensure regular revaluation of physical assets in vulnerable zones

6. Review Off-Balance Sheet Exposure Controls

   • Reassess CCF assumptions for credit lines and guarantees

   • Monitor early-warning signals for potential OBS conversion

7. Build Climate Risk Capabilities

   • Train credit, treasury, and model risk teams in climate risk data and frameworks

   • Collaborate with ESG data providers, regulators, and insurers

8. Align with Global Frameworks and Standards

   • Adopt TCFD, NGFS, and Basel guidance on climate risk

   • Participate in climate risk disclosures and industry-wide stress testing

Flooding is no longer just a natural disaster — it’s a stress test for every aspect of a bank’s balance sheet.

From liquidity shocks to asset impairments and off-balance sheet risks, floods demand robust climate-resilient strategies. As ESG and climate regulations evolve, banks must climate-proof their balance sheets — just as they do for credit, market, and capital risk.

The Impact of Transition Climate Risks on Banks

What Are Transition Climate Risks?

Transition risks arise from the global shift toward a low-carbon economy. Unlike physical climate risks (such as floods or heatwaves), these are driven by regulatory, technological, market, and social changes associated with decarbonization efforts.

These risks can significantly affect a bank’s credit quality, market valuation, operational models, and reputation — especially for those exposed to carbon-intensive sectors.

Types of Transition Risks

1. Policy & Regulatory Risk

New climate policies such as carbon pricing, emissions caps, and energy efficiency mandates can make certain industries less profitable or even unviable.

Examples:

1. Carbon taxes or emissions trading schemes

2. Climate-related disclosures by BIS, ECB, TCFD, ISSB

3. Green finance regulations or taxonomies

2. Technology Risk

Advancements in clean technologies (e.g., solar, electric vehicles, hydrogen) can disrupt existing industries and render traditional assets obsolete.

Example: Rapid EV adoption lowers residual values of internal combustion engine (ICE) vehicle loans.

3. Market & Economic Risk

Changing consumer preferences and investor sentiment can trigger repricing of carbon-intensive assets (e.g., coal, oil, cement). This may lead to credit rating downgrades or equity value erosion.

4. Reputational Risk

Banks that continue financing high-emission industries may face backlash from investors, regulators, and the public, leading to divestment by ESG-conscious stakeholders.

How Transition Risks Affect Banks

Transition climate risks can affect banks across several dimensions:

Credit Risk

• Sectoral Exposure: Carbon-intensive borrowers (coal, steel, power, auto) may become less viable.

• Default Probability: Regulatory tightening, rising costs (e.g., carbon taxes), and reduced competitiveness may increase defaults.

• Asset Impairment: Collateral such as fossil fuel assets or factories may depreciate or become stranded.

Market Risk

• Repricing of Assets: Equity and bond valuations for carbon-intensive firms may fall sharply.

• Volatility: Market shocks can occur due to policy announcements (e.g., ICE vehicle bans, carbon border taxes).

• Sovereign Risk: Countries reliant on fossil fuel exports may experience currency and yield instability.

Capital & Provisioning Risk

• Higher Capital Needs: Regulators may mandate increased capital buffers for high-risk exposures.

• Forward-Looking ECLs: Under IFRS 9, expected credit loss models must consider future transition risks.

• Capital Adequacy Strain: Downgrades and provisioning shocks may stress CAR/CRAR levels.

Liquidity Risk

• Withdrawal Risk: Reputational concerns may prompt fund withdrawals by institutional or ESG-sensitive investors.

• Funding Costs: Weak ESG ratings may impair access to green or sustainable financing lines.

Operational & Strategic Risk

• Model Limitations: Traditional underwriting models may ignore carbon or ESG variables.

• Business Model Pressure: Legacy products (e.g., diesel auto loans) may no longer suit evolving customer or regulatory expectations.

Reputational Risk

• Stakeholder Scrutiny: NGOs, media, and ESG stakeholders increasingly demand sustainable practices.

• Brand Damage: Financing polluting sectors can lead to reputational downgrades and public backlash.

Off-Balance Sheet Risk

• Undrawn Limits: Borrowers under stress may draw unused lines, elevating funding and credit risk.

• Guarantees/LCs: May be triggered if clients default or face regulatory shutdowns.

Example Transition Risk Scenarios

Sector	Transition Trigger	Banking Impact
Power (Coal)	Carbon tax, renewable energy mandates	Credit downgrade, loan impairment
Auto (ICE)	EV subsidies, ICE bans	Decline in collateral value for auto loan portfolios
Cement/Steel	Emissions caps, green certifications	Higher financing costs, ESG-driven divestment
Real Estate	Green building code enforcement	Reduced lending to non-compliant developers

How Banks Can Prepare for Transition Risk

A. Portfolio Risk Assessment

• Identify exposure to high-emission sectors (energy, auto, steel, cement)

• Map financed emissions (Scopes 1–3)

• Assess stranded asset risk under transition scenarios

B. Climate Stress Testing

• Model carbon pricing, policy shocks, and sector-specific bans

• Analyze impact on PD, LGD, EAD and capital ratios

• Align with NGFS, IEA, and national climate strategies

C. Risk Appetite & Policy Integration

• Define exposure limits for high-risk sectors

• Incorporate ESG-linked scorecards and limits

• Set climate risk thresholds within ERM and RAS

D. Model Enhancements

• Integrate ESG metrics into credit scoring models

• Revise IRB/Standardized models for carbon exposure

• Adjust ICAAP scenarios to include transition triggers

E. Product & Client Strategy

• Develop green products: sustainability-linked loans (SLLs), green bonds

• Create carbon-adjusted loan pricing models

• Offer ESG advisory to help clients decarbonize

F. Disclosures, Governance & Oversight

• Align disclosures with TCFD, ISSB, ECB, BIS

• Strengthen ESG oversight at board and executive levels

• Track and report emissions and green portfolio metrics

G. Capacity Building & Tools

• Train relationship managers, risk, treasury, and audit teams on climate risk

• Integrate ESG data vendors into decision-making

• Establish a cross-functional climate risk task force

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Auronova Consulting is a specialized risk-management firm serving banks and financial institutions with consulting, analytics, implementation support, and compliance advisory. Over the past decade, it has worked with 100+ clients across multiple countries on 500+ engagements spanning credit, market, liquidity, operational risk, and regulatory programs, led by partners with 20+ years’ experience. The firm’s focus is using risk as a strategic lever for value creation.