Incorporating physical climate risks into banks' credit risk models

Over the past few years, physical risks have turned from a niche domain of (re)insurers into a systemic risk factor that may have an impact through various channels on financial markets and financial institutions alike. While physical risks are not a common income-producing or even a sizeable cost-ofbusiness risk factor for most banks, they do affect banks, mostly indirectly, through their loan and trading books. Against this backdrop, standard setting bodies and financial regulators have increasingly called on banks to recognise physical risks as an additional factor in their risk space and internalise it in their risk management policies. A major obstacle for banks on this way, however, is the absence of generally accepted industry models of credit risk adjusted for physical risk factors. Such models are increasingly needed to account for physical risks in banks' capital requirements, loan loss provisions, pricing of loans and, eventually, derivatives to hedge this risk. This poses the question of building a bank's internal model for climaterelated correction to the internal probability of default and loss given default or using third-party databases on the type of the borrower's assets, their geolocation, exposure to climate factors, statistical description of weather events and damage functions. This paper proposes a methodology that allows in a relatively simple way the integration of physical risk component into the credit risk modelling, using an extension of the one-factor Vasicek model. The model described by the paper may be of specific interest for both banks and regulators, as it preserves important properties of models currently used while allowing for an informed mitigation of physical risk factor in credit risk. Additionally, the paper discusses further possible extensions of the credit risk model if physical risk manifests itself in more than one state.