Banks

Enhancing Enterprise Risk Management in Banks with Riskthinking’s Climate Digital Twin

Introduction

Climate change presents significant risks to the financial sector, with banks increasingly facing physical, market, credit, liquidity, operational, and regulatory challenges. Financial institutions need advanced tools to deliver accurate risk assessments and predictive analytics to effectively tackle these threats. Riskthinking’s Climate Digital Twin (CDT™) provides an innovative solution, enabling banks to simulate climate-related disruptions and enhance enterprise risk management (ERM) strategies. With extensive global coverage of hazards (over 50), more than 5,000,000 physical assets, high-accuracy downscaling, multifactor stress testing, and stochastic modelling, it spans the entire globe. By utilizing this technology, banks can better anticipate potential losses, bolster resilience by understanding tail risk, and ensure compliance with evolving regulations.

Key Climate-Related Risks in Banking

1. Market Risk

Definition and Drivers

Market risk arises when climate-induced volatility affects asset valuations. Properties in floodplains or wildfire-prone regions may suddenly depreciate, diminishing the value of real estate holdings and mortgage-backed securities. Investors, wary of heightened uncertainty, may shift capital away from sectors or markets perceived as vulnerable to climate disruptions. This reallocation can trigger rapid price swings in equities, bonds, and other financial instruments.

Implications for Banks

• Erosion of Portfolio Value: A decrease in the values of real estate and asset-backed securities directly affects banks’ investment and loan portfolios.

• Investor Sentiment Shifts: Increased volatility may lead to sell-offs in climate-sensitive assets, which could jeopardize the overall stability of banks.

Role of the Climate Digital Twin

By simulating various climate scenarios and their effects on asset prices, Riskthinking’s Climate Digital Twin provides financial institutions with an early warning system for market fluctuations. This enables banks to rebalance portfolios, hedge against potential losses, and make informed investment choices.

2. Credit Risk

Definition and Drivers

Credit risk arises when climate-related events devalue assets used as loan collateral, such as residential and commercial real estate. Physical climate risks—hurricanes, floods, wildfires, and rising sea levels—can damage properties, reducing their market value and increasing the likelihood of borrower defaults. In high-risk regions, the perception of future climate threats can also restrict access to credit, raising lending costs.

Implications for Banks

• Increased Default Rates: Property damage or business interruptions can cause financial hardships, making it difficult for borrowers to repay loans.

• Decreasing Collateral Value: Lower property values result in banks recovering less during foreclosure situations, leading to increased credit losses.

• Restricted Lending in Vulnerable Areas: Investors might hesitate to fund businesses and properties in high-risk zones, which limits economic activity in those regions.

Role of the Climate Digital Twin

Riskthinking’s Climate Digital Twin assists banks in evaluating how climate events may affect

the value of collateralized assets over time. By integrating climate scenario modelling, financial institutions can enhance loan terms, modify risk pricing, and strategically allocate capital to reduce credit exposure in at-risk areas.

3. Liquidity Risk

Liquidity risk becomes critical when climate shocks trigger sudden cash flow pressures. In the aftermath of disasters, individuals and businesses need immediate access to funds for recovery efforts. Moreover, if confidence in the financial system declines, depositors may withdraw their funds en masse, and investors might demand higher premiums or stricter lending terms. These simultaneous cash demands can put pressure on a bank’s short-term liquidity, especially if multiple institutions in an affected region face similar challenges.

Implications for Banks

• Increased Withdrawal Rates: Households and businesses might withdraw deposits to address emergency expenses.

• Tighter Credit Conditions: Investors might hesitate to renew short-term funding, resulting in increased financing costs.

Role of the Climate Digital Twin

By analysing historical and projected climate shocks, the Climate Digital Twin helps banks forecast liquidity needs, strengthen capital buffers, and create contingency funding plans to withstand financial pressures during climate-related crises.

4. Operational Risk

Definition and Drivers

Extreme weather events, such as hurricanes and floods, can directly impact a bank’s physical infrastructure, including branches, data centers, and ATM networks. Furthermore, operational disruptions can extend beyond a bank’s direct facilities, affecting third-party providers, such as cloud service vendors and outsourced partners, and creating a cascading effect on essential banking functions.

Implications for Banks

• Service Interruptions: Damage to physical infrastructure can disrupt core banking operations, including transaction processing and customer support.

• Supply Chain Vulnerabilities: Reliance on external vendors could increase operational risks if those providers are also impacted by climate events.

Role of the Climate Digital Twin

The Climate Digital Twin maps climate risks across supply chains and infrastructure networks, enabling banks to safeguard critical operations proactively. This includes identifying vulnerable facilities, developing backup systems, and optimizing disaster recovery strategies to minimize downtime.

5. Regulatory Compliance Risk

Definition and Drivers

Regulatory bodies worldwide are implementing stricter requirements for financial institutions to integrate climate considerations into their risk management frameworks. This includes climate stress testing, transparent disclosures regarding high-risk asset exposure, and the development of comprehensive disaster response plans. Banks that fail to comply with these mandates risk facing financial penalties, legal scrutiny, and potential damage to their reputation.

Implications for Banks

• Regulatory Scrutiny: Growing expectations from policymakers and supervisory bodies could result in increased oversight.

• Possible Penalties: Non-compliance with climate disclosure requirements could result in fines and restrictions.

Role of the Climate Digital Twin

The Climate Digital Twin streamlines compliance with regulatory frameworks by automating data collection and analysis. It provides detailed climate stress test reports, enhances transparency in climate risk disclosures, and helps banks demonstrate proactive risk mitigation strategies to regulators and stakeholders.

Strengthening ERM with Riskthinking’s Climate Digital Twin

Comprehensive Risk Assessment

By integrating climate data with financial models, Riskthinking.ai’s Climate Digital Twin enables banks to assess various risk types—credit, market, liquidity, operational, and regulatory— within a unified framework. This comprehensive approach empowers institutions to enhance resilience across all facets of their risk management strategies.

Scenario Planning and Stress Testing

The Digital Twin enables advanced scenario planning by allowing banks to simulate how various climate trajectories may affect their portfolios. This aids in developing mitigation plans customized for different climate contingencies, ensuring readiness for future uncertainties.

Strategic Decision-Making

Banks can make well-informed decisions regarding portfolio allocation, capital reserves, and lending policies with advanced analytics and real-time data insights. This forward-looking strategy enhances financial stability while aligning with regulatory expectations and investor confidence.

Enhancing Stakeholder Trust

As climate risks gain prominence, banks that adopt cutting-edge risk assessment tools signal their commitment to sustainable finance and responsible investment. This proactive approach strengthens stakeholder confidence and ensures long-term institutional credibility.

Conclusion

Climate change is an increasingly critical factor in financial risk management, necessitating that banks adopt advanced tools for assessing and mitigating threats. Riskthinking’s Climate Digital Twin offers a powerful solution, enabling financial institutions to model climate impacts, refine risk strategies, and bolster overall resilience. By leveraging this technology, banks can effectively manage climate-related risks, comply with regulatory obligations, and uphold financial stability amid growing environmental uncertainty.