IDEAS home Printed from https://ideas.repec.org/p/bis/biswps/1274.html
   My bibliography  Save this paper

Incorporating physical climate risks into banks' credit risk models

Author

Listed:
  • Vasily Pozdyshev
  • Alexey Lobanov
  • Kirill Ilinsky

Abstract

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.

Suggested Citation

  • Vasily Pozdyshev & Alexey Lobanov & Kirill Ilinsky, 2025. "Incorporating physical climate risks into banks' credit risk models," BIS Working Papers 1274, Bank for International Settlements.
  • Handle: RePEc:bis:biswps:1274
    as

    Download full text from publisher

    File URL: https://www.bis.org/publ/work1274.pdf
    File Function: Full PDF document
    Download Restriction: no

    File URL: https://www.bis.org/publ/work1274.htm
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Alexander Blasberg & Rüdiger Kiesel & Luca Taschini, 2022. "Carbon Default Swap - Disentangling the Exposure to Carbon Risk through CDS," CESifo Working Paper Series 10016, CESifo.
    2. Egemen Eren & Floortje Merten & Niek Verhoeven, 2022. "Pricing of climate risks in financial markets: a summary of the literature," BIS Papers, Bank for International Settlements, number 130.
    3. Gordy, Michael B., 2003. "A risk-factor model foundation for ratings-based bank capital rules," Journal of Financial Intermediation, Elsevier, vol. 12(3), pages 199-232, July.
    4. Florian Bourgey & Emmanuel Gobet & Ying Jiao, 2024. "An Efficient SSP-based Methodology for Assessing Climate Risks of a Large Credit Portfolio," Post-Print hal-04691603, HAL.
    5. Agliardi, Elettra & Agliardi, Rossella, 2021. "Pricing climate-related risks in the bond market," Journal of Financial Stability, Elsevier, vol. 54(C).
    6. Francesca Bell & Gary van Vuuren, 2022. "The impact of climate risk on corporate credit risk," Cogent Economics & Finance, Taylor & Francis Journals, vol. 10(1), pages 2148362-214, December.
    7. Baranović, Ivana & Busies, Iulia & Coussens, Wouter & Grill, Michael, 2021. "The challenge of capturing climate risks in the banking regulatory framework: is there a need for a macroprudential response?," Macroprudential Bulletin, European Central Bank, vol. 15.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Livieri, Giulia & Radi, Davide & Smaniotto, Elia, 2024. "Pricing transition risk with a jump-diffusion credit risk model: evidences from the CDS market," LSE Research Online Documents on Economics 123650, London School of Economics and Political Science, LSE Library.
    2. Klaus Duellmann & Martin Erdelmeier, 2009. "Crash Testing German Banks," International Journal of Central Banking, International Journal of Central Banking, vol. 5(3), pages 139-175, September.
    3. Xin Huang & Hao Zhou & Haibin Zhu, 2012. "Systemic Risk Contributions," Journal of Financial Services Research, Springer;Western Finance Association, vol. 42(1), pages 55-83, October.
    4. Patrick Gagliardini & Christian Gouriéroux, 2011. "Approximate Derivative Pricing for Large Classes of Homogeneous Assets with Systematic Risk," Journal of Financial Econometrics, Oxford University Press, vol. 9(2), pages 237-280, Spring.
    5. Metzler A., 2020. "State dependent correlations in the Vasicek default model," Dependence Modeling, De Gruyter, vol. 8(1), pages 298-329, January.
    6. Arturo Cortés Aguilar, 2011. "Estimación del residual de un bono respaldado por hipotecas mediante un modelo de riesgo crédito: una comparación de resultados de la teoría de cópulas y el modelo IRB de Basilea II en datos del merca," Revista de Administración, Finanzas y Economía (Journal of Management, Finance and Economics), Tecnológico de Monterrey, Campus Ciudad de México, vol. 5(1), pages 50-64.
    7. Mendicino, Caterina & Nikolov, Kalin & Ramirez, Juan-Rubio & Suarez, Javier & Supera, Dominik, 2020. "Twin defaults and bank capital requirements," Working Paper Series 2414, European Central Bank.
    8. Rainer Masera, 2014. "CRR/CRD IV: the trees and the forest," PSL Quarterly Review, Economia civile, vol. 67(271), pages 381-422.
    9. Pacelli, Vincenzo & Di Tommaso, Caterina & Foglia, Matteo & Povia, Maria Melania, 2025. "Spillover effects between energy uncertainty and financial risk in the Eurozone banking sector," Energy Economics, Elsevier, vol. 141(C).
    10. Hengxin Cui & Ken Seng Tan & Fan Yang, 2024. "Portfolio credit risk with Archimedean copulas: asymptotic analysis and efficient simulation," Annals of Operations Research, Springer, vol. 332(1), pages 55-84, January.
    11. Trueck, Stefan & Rachev, Svetlozar T., 2008. "Rating Based Modeling of Credit Risk," Elsevier Monographs, Elsevier, edition 1, number 9780123736833.
    12. Lionel Sopgoui, 2024. "Impact of Climate transition on Credit portfolio's loss with stochastic collateral," Papers 2408.13266, arXiv.org, revised May 2025.
    13. Carole Bernard & Ludger Rüschendorf & Steven Vanduffel & Ruodu Wang, 2017. "Risk bounds for factor models," Finance and Stochastics, Springer, vol. 21(3), pages 631-659, July.
    14. Nicholas M. Kiefer, 2011. "Default estimation, correlated defaults, and expert information," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 26(2), pages 173-192, March.
    15. Bandyopadhyay, Arindam, 2011. "Internal Assessment of Credit Concentration Risk Capital: A Portfolio Analysis of Indian Public Sector Bank," MPRA Paper 28672, University Library of Munich, Germany.
    16. Rosen, Dan & Saunders, David, 2009. "Analytical methods for hedging systematic credit risk with linear factor portfolios," Journal of Economic Dynamics and Control, Elsevier, vol. 33(1), pages 37-52, January.
    17. Abel Elizalde & Rafael Repullo, 2007. "Economic and Regulatory Capital in Banking: What Is the Difference?," International Journal of Central Banking, International Journal of Central Banking, vol. 3(3), pages 87-117, September.
    18. Paul Kupiec, 2007. "Financial stability and Basel II," Annals of Finance, Springer, vol. 3(1), pages 107-130, January.
    19. Rösch, Daniel & Scheule, Harald, 2009. "The Empirical Relation between Credit Quality, Recovery and Correlation," Hannover Economic Papers (HEP) dp-418, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
    20. Janette Larney & Arno Botha & Gerrit Lodewicus Grobler & Helgard Raubenheimer, 2025. "A cost of capital approach to determining the LGD discount rate," Papers 2503.23992, arXiv.org.

    More about this item

    Keywords

    ;
    ;
    ;
    ;
    ;

    JEL classification:

    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • P28 - Political Economy and Comparative Economic Systems - - Socialist and Transition Economies - - - Natural Resources; Environment
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:bis:biswps:1274. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Martin Fessler (email available below). General contact details of provider: https://edirc.repec.org/data/bisssch.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.