Understanding Climate Risk in Banking: A Strategic and Financial Imperative

Climate change has evolved from being a peripheral concern to a core financial risk for the banking sector. Increasingly, banks are being called upon to recognize, quantify, and manage the impact of climate-related events — not just for reputational alignment, but to safeguard their credit portfolios, operational resilience, and long-term financial stability.

At the heart of this shift are two key forms of climate risk:

• Physical risk, which stems from the direct impact of climate-related events such as floods, droughts, hurricanes, or rising sea levels. These can damage property, disrupt infrastructure, and severely impair the cash flows of borrowers in climate-sensitive sectors.

• Transition risk, which arises from the global push toward a low-carbon economy. As governments and industries shift toward sustainable energy and regulatory frameworks tighten, companies face risks from carbon pricing, policy changes, technological disruption, and changing consumer behaviour.

Banks are directly exposed to both categories. A borrower’s inability to repay due to climate events, or a sudden devaluation of a coal-fired plant due to regulatory shifts, directly affects a bank’s loan book, capital requirements, and risk profile.

How Climate Risk Translates into Banking and the Broader Economy

The transmission of climate risk into banking is multi-faceted. Physical risk can lead to asset devaluation, increased defaults in housing or agricultural loans, and even operational disruptions at branch or data centre levels. Transition risk may lead to stranded assets, sector-wide credit deterioration, or volatility in investment portfolios linked to fossil fuels or non-compliant industries.

At a macroeconomic level, climate change can act as a drag on GDP, increase inflation (e.g., via food and energy shocks), and erode household and corporate balance sheets. When left unchecked, these risks can escalate into systemic financial instability, especially for economies heavily reliant on carbon-intensive sectors.

Examples of Climate Risks in Banking

Physical risk examples include:

• Repeated flooding in coastal regions reducing the value of mortgaged properties.

• Prolonged droughts affecting agricultural output and causing widespread loan defaults in farming communities.

• Storm damage to infrastructure projects financed by long-term loans.

Transition risk examples include:

• Introduction of carbon taxes that undermine the profitability of large industrial borrowers.

• Decline in value of oil & gas projects due to policy bans or subsidy withdrawals.

• Market shifts toward electric vehicles (EVs), reducing resale value of ICE vehicle loan collateral.

These examples underline how deeply embedded climate variables are in banking portfolios — and how critical it is for institutions to understand and respond to them.

Regulatory Momentum and Supervisory Expectations

Global regulatory bodies such as the Basel Committee on Banking Supervision (BCBS) and national supervisors are placing increased focus on climate risk. Expectations now include integrating climate factors into governance and risk appetite, conducting climate-aligned scenario analysis, and disclosing exposures in line with TCFD (Task Force on Climate-related Financial Disclosures) standards.

Banks are also being encouraged to recalibrate credit models to include climate-related variables and stress their portfolios under forward-looking climate scenarios such as those issued by the Network for Greening the Financial System (NGFS) or the International Energy Agency (IEA).

Strengthening Risk Management

To address this emerging risk class, leading banks are investing in:

• Data infrastructure to source borrower-level emissions data, physical risk exposure, and sector-specific climate sensitivity.

• Scenario-based stress testing to simulate outcomes under different global warming or transition pathways.

• Portfolio analytics to assess financed emissions and exposure to carbon-intensive assets.

• Client engagement strategies to support borrowers in decarbonizing their operations through sustainability-linked lending and green finance solutions.

Banks are also aligning their capital planning processes, such as ICAAP, with climate-adjusted risk assessments — ensuring that capital buffers account for potential future volatility related to climate change.

A Strategic Opportunity

Beyond risk mitigation, climate risk management presents a significant business opportunity. Financial institutions that lead in this space can access green capital, strengthen stakeholder trust, and develop new products that align with environmental goals — from green bonds and transition finance to climate-risk-adjusted pricing models.

In the coming years, banks that internalize climate considerations into their strategy, underwriting, and operations will be better positioned to navigate regulatory changes, investor scrutiny, and evolving customer expectations. Climate risk is not only a risk to be managed — it is a defining factor of resilience and competitiveness in the future of banking.

The Impact of Physical Risk on Banks and How to Manage It

Physical risk, one of the two pillars of climate risk, refers to potential financial losses from acute climate events (like floods or heatwaves) and chronic changes (like desertification or sea-level rise). For banks, especially those in the GCC where urbanization and infrastructure are highly exposed to extreme weather, managing physical risk has become a priority.

How Physical Risk Impacts Banks

1. Credit Risk

• Floods, extreme heat, and storms can damage borrower assets, disrupt income, and lead to defaults.

• Collateral values—especially in real estate—may decline due to repeated exposure to uninsurable events.

• Certain sectors (e.g., construction, retail, agriculture) and locations (coastal, low-lying) are especially vulnerable.

2. Operational Risk

• Extreme temperatures or flooding can impair branch operations, data centres, or logistics.

• Utilities disruptions can affect payments, collections, and customer service channels.

3. Liquidity & Market Risk

• Climate events can cause rapid deposit withdrawals or increased drawdowns on committed lines.

• Asset valuations may shift for climate-exposed sectors, affecting trading portfolios.

4. Regulatory and Legal Risk

• Central banks across the GCC (e.g., UAE Central Bank, SAMA, CBK) are increasingly aligning with global climate stress testing.

• Inadequate climate risk disclosures may trigger penalties or reputational harm.

How Banks Can Manage Physical Risk

• Climate Data Integration: Use satellite and hazard data to overlay risk maps on customer exposures.

• Climate Scenario Analysis: Run flood and heat stress simulations on loan portfolios using forward-looking data.

• Policy Adjustments: Apply stricter LTV and insurance requirements in flood-prone zones.

• Risk-Based Pricing: Adjust loan pricing to account for borrower and property-level climate exposure.

• Capital Planning: Integrate climate risk into ICAAP, ERM, and recovery plans.

• Disclosure & Governance: Align with ISSB/TCFD frameworks and appoint climate risk ownership at board level.

Case Study: Pluvial Flood Risk Assessment by a Leading GCC Bank

Bank: One of the largest commercial banks headquartered in the Gulf Cooperation Council (GCC) region

Objective: Quantify and manage pluvial (rain-induced) flood risk exposure across its urban mortgage and SME portfolios, particularly in rapidly expanding coastal cities.

Context:

While GCC countries are generally arid, climate change has led to more frequent extreme rainfall events, causing urban flooding due to poor drainage infrastructure—a growing challenge in cities like Dubai, Jeddah, Doha, and Manama. The bank's concern: these events could threaten collateral values and disrupt SME operations.

Risk Assessment Approach

1. Geolocation of Assets

   • Geo-tagged 100% of mortgaged properties and SME premises across the UAE, Saudi Arabia, and Bahrain using customer address and GIS tools.

2. Climate & Hazard Data Overlay

   • Partnered with a global climate analytics provider and regional meteorological services.

   • Used pluvial flood hazard maps to identify areas with risk from 1-in-30 and 1-in-100 year rainfall events, simulating ponding depth and drainage failure.

3. Portfolio Analysis

   • ~18% of the real estate loan book was found to be in moderate to high flood risk zones—mostly in older coastal districts and rapidly urbanized suburbs.

   • Several SME customers were clustered in areas where recurrent flash floods had previously caused physical damage and cash flow disruption.

4. Scenario Stress Testing

   • Ran an adverse scenario simulating a 1-in-100-year rainfall event hitting Dubai, Sharjah and Eastern Riyadh.

   • Applied adjusted PD/LGD using proxy data from past flood losses in the region.

   • Result: Projected a 40–70 bps increase in NPL ratio in affected segments, and a 7–9% drop in collateral values.

Mitigation Actions Taken

• Credit Policy Update: Imposed mandatory flood insurance for high-risk zones; tightened LTV thresholds for new housing loans in red-zoned areas.

• SME Support Package: Launched pre-approved credit lines and grace-period policies for SMEs operating in flood-prone industrial parks.

• Operational Preparedness: Identified at-risk branches and ATMs for continuity planning and backup infrastructure deployment.

• Climate Dashboard: Developed a real-time risk dashboard integrating asset location, flood zone data, and exposure metrics.

• Disclosure: Incorporated physical risk disclosures aligned with ISSB standards in its latest sustainability report.

This case study highlights the urgency and feasibility of embedding physical risk into the GCC banking ecosystem. With climate events becoming more unpredictable—even in traditionally dry regions—banks must go beyond conventional credit assessments. Tools like geo-mapping, flood modeling, and climate-adjusted loss forecasting will be central to ensuring long-term resilience, regulatory compliance, and portfolio performance.

This is Part 1 of our series. Part 2 steps deeper into the story- how floods can drain liquidity in hours, how balance sheets absorb the shock, and how the global shift to low-carbon economies rewrites credit, capital, and strategy. Stay tuned.

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About the Organization

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.